How to stay clear of the legal issues and tax ramifications of freelancer misclassification
Today’s startups, small businesses, and enterprises are increasingly relying on freelancers and contract service vendors. This allows companies to keep their employee counts low while getting support for specific projects and on-demand access to expertise at lower costs.
Legal Issues and Tax Ramifications of Freelancer Misclassification
At the same time, the government is cracking down on employers who misclassify workers as independent contractors. This increased scrutiny by federal and state governments is partly based on growing tax revenue. For 1099 workers, employers don’t have to pay or withhold income taxes, Social Security, Medicare, disability, or unemployment taxes (which they do for employees). In addition, some employers use freelancers to stay under the 50-employee threshold. Under federal health care law, employers with 50 or more employees have to pay for employee health insurance (or pay a penalty).
Unfortunately, even well-intentioned employers sometimes misclassify workers. Young startups (where entrepreneurs believe it’s important to do more faster) are, particularly at risk. If you’re found to have made a mistake in classifying a W2 employee as a 1099 independent contractor, there are numerous penalties and ramifications. In particular, you may be required to pay back taxes and penalties for federal and state income taxes, Social Security, Medicare, and unemployment.
10 Practical Tips for Independent Contractor Compliance — How to Prevent Legal Issues When Hiring Freelancers
Although the IRS may be cracking down on employers, you shouldn’t be afraid to work with freelancers and service vendors — as long as they are properly classified with appropriate documentation. Here are a few tips to stay compliant.
1. Hire freelancers who have incorporated their business, instead of those who operate as sole proprietors.
Hiring contractors who have incorporated their business helps to prove that they have their own business model, which is one of the most effective ways to avoid auditing trouble. However, not every freelancer you’d like to use will be incorporated, so make sure to follow our other tips. Liquid encourages contractors to use an EIN (versus SSN), which makes it clearer that you are using a 1099 worker (versus someone you should be hiring as a W2 employee).
2. Hire freelancers who have more than one client.
If you are a freelancer’s only client for the year, that raises red flags. It’s not a big deal if someone is just getting started and doesn’t have other clients yet — just verify that the freelancer is actively marketing or advertising their services. When you use an FMS like Liquid, your freelancers can choose to be in our searchable database of independent contractors/vendors — and they can simultaneously work on projects with many clients.
3. Be sure to sign independent contractor agreements with each and every freelancer.
Signing an independent contractor agreement with every freelancer reinforces the independent contractor classification. Be sure you talk to an attorney to include all essential components in your independent contractor agreements/freelance contract agreements. On Liquid, you can use our standard template or bring your own attorney-approved boilerplates.
Download our guide to the Essential Components of an Independent Contractor Agreement.
4. Ask for a W-9 form during the onboarding process.
Whereas businesses request W-4 Forms from their W2 employees, businesses request IRS Form W-9 to get taxpayer information from 1099 independent contractors and vendors. The W-9 (Request for Taxpayer Identification Number and Certification) does not inherently arrange for the withholding of any taxes due, as any required taxes based on gains related to the provided W-9 are the responsibility of the TIN holder listed on the document.
In some cases, the taxpayer is subject to backup withholding which would be noted accordingly on the W-9 and the business would then need to withhold accordingly. In Liquid, every onboarding process requires W-9 completion. Those completed W-9 forms are securely stored for future access within Liquid.
5. Make sure all freelancers issue invoices for their work.
Every freelancer payment should be associated with an invoice. Pay freelancers for deliverables and project milestones, instead of paying them bi-weekly, weekly, or monthly like you would pay an employee. Liquid automatically creates invoices for freelancers/vendors and issues reminders to freelancers to send invoices according to agreed-upon SOWs.
6. Don’t exert too much control or supervision over a freelancer.
Avoid determining specific hours for when your freelancers need to work, as that opens your business up to legal issues when hiring freelancers. You can set deadlines but should avoid setting such tight deadlines that your freelancers have to work full-time for you. Liquid makes it easy to create SOWs with clearly defined tasks (deliverables) and due dates for every project.
7. Don’t put freelancers into the same platform, system, or software for managing employees.
Using Liquid allows you to separate the management of your full-time employees from your outside contractors and vendors. This separation provides several benefits for your company. The business requirements for freelancer processes (such as sourcing, onboarding, managing, and paying) are not the same as those for HR processes for employees. Additionally, if you have independent contractors on the same systems that are used to manage employees, you are more at risk of violating the ABC test.
8. Don’t call your freelancers employees.
Don’t give any independent contractors your employee handbook or ever refer to them as an employee of your business. With Liquid, you can easily establish and manage the specific onboarding process for your freelancers. The workflow includes controls to help ensure compliance with regulations.
9. Don’t tell your freelancers where to work.
Don’t ask your freelancers to work at your office or provide them with equipment unless it’s absolutely necessary. This is a critical component of independent contractor classification — controlling where and how independent contractors work means the person you are working with should be hired as a W-2 employee.
10. Send Form 1099s to every freelancer.
Issue a Form 1099 to all independent contractors within the appropriate time frame. A 1099 (specifically a 1099-NEC) is used to report payments made to independent contractors (who must cover their own employment taxes). A W-2 form is used for employees (whose employer withholds payroll taxes from their earnings). This is mandatory, as every auditor will first ask to see your 1099s.
By being smart and playing by the rules, you can avoid legal issues when hiring freelancers — and activate the liquid workforce to power your business. Talk to your tax professional or employment attorney to learn more about how to properly classify your workers.