Are you aware of just how important it is to properly classify those who work for you? It’s crucial that you accurately classify them. Otherwise, you could face serious consequences from the IRS!
Even deeper than that, the reclassification process is a bit complex. You can’t simply decide to reclassify an employee as a freelancer and that’s that. You’ll also have to change the professional relationship and what you expect from your employee-turned-freelancer.
What are the advantages of working with freelancers?
Freelancers are beneficial hires because they provide top-tier flexibility. In other words, you’ll have someone who can meet a very specific need of yours, and that person will only work for you until that need is met.
What are the disadvantages of working with freelancers?
While you have every right to expect your employees to work at certain times, you cannot expect the same of freelancers. They get to decide when and where they work. More specifically, freelancers are in full control of the work that they will do, the schedules they adhere to and the way they perform the services they offer.
The IRS’ rules for classifying workers
The IRS encourages employers to consider a variety of factors when deciding whether they are hiring an employee or paying a freelancer: How much control do you need to have over the individual’s workflow? Will they work independently on their own time, or do you expect them to abide by a schedule you have imposed? What type of business relationship have you formed — a short-term contract-based one, or a long-term one?
How employees and freelancers differ in the eyes of the IRS
Let’s take a look at the main differences between hiring employees and paying freelancers.
Employees
With employees, you are responsible for withholding federal income taxes from their paychecks, including Medicare and Social Security. Some employees might live in parts of the country where state income taxes must be withheld too.
Employees’ expenses are taken care of by employers, and employees are often eligible for a wide array of benefits. From health insurance and retirement plans to paid time off and more, these perks are a major benefit of being employed, as are the stability and structure afforded by the employment status.
Freelancers
Alternatively, since freelancers are independent contractors, they must withhold taxes from their own income, and they will pay self-employment taxes directly to the IRS on a quarterly basis. This includes Social Security and Medicare.
Freelancers get to deduct expenses come tax time. These deductions typically entail office expenses, work-related mileage and equipment required to complete the jobs at hand. While freelancers do not receive benefits like employees do, independent contractors have the luxury of setting their own schedules, choosing the work they will do and naming their hourly rates.
The penalties for misclassifying workers
Interestingly enough, there was a point in time when the Department of Labor discovered several companies that wrongly labeled their employees as contractors. This resulted in nearly $180,000 worth of recovered back wages, and that was only one instance of many!
As you can see, misclassification — otherwise known as treating employees as freelancers or vice versa — is a major issue. When employees are misclassified, they are not allowed access to benefits they technically deserve. Similarly, freelancers misclassified as employees could end up experiencing harm to their business due to the restrictive nature of contracts that require a set number of hours or fixed schedules.
In most cases of misclassification, the law generally sides with workers because a misclassified worker tends to create circumstances that favor companies, not workers. For instance, evading compliance with labor laws allows businesses to enjoy the advantages of full-time employees without providing benefits to them in return.
However, this is quite a risk on the part of the business because misclassified workers can sue and tax auditors can investigate, at which point the company would owe substantial fines. Some of the penalties that the IRS could impose are as follows:
- 1.5% of employee wages
- Fines for each misclassified employee
- 40% to 100% of FICA taxes that are owed
Furthermore, businesses could be subject to legal consequences as well, such as wage and tax audits, compensation for unpaid wages, class-action lawsuits, or criminal charges in cases where misclassification was an intentional decision rather than an accident.
How to prevent the misclassification of workers
The best way to avoid the prospect of misclassifying those who work for you is to familiarize yourself with what the IRS uses to determine worker classification statuses. The IRS uses the Common Law Test to classify workers as freelancers or employees.
This test is essentially a checklist of 20 factors that differentiate employees and freelancers from one another. If you look at this test for yourself, you can analyze your work relationships the same way the IRS does, which ensures you’re on the same page as the government.
If you want the IRS to determine the classification of your workers on your behalf, you can also file Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. This document will cause the IRS to review the facts and circumstances pertaining to your workers, and the IRS will directly tell you how to classify each person you request an analysis for.
The bottom line is that you should speak with experienced HR professionals and tax advisers, both of which can make sure you’re classifying your staff members correctly.
