How to treat freelancers as independent contractors, so you won’t be liable for their payroll taxes and healthcare benefits
By Alan G. Orlowsky, J.D., C.P.A. and David M. Freedman
In the 1990s, Microsoft Corp. supplemented its workforce by hiring “freelance” computer programmers. The freelancers signed agreements when they were hired, stipulating that they would work as independent contractors, receiving cash payments for their services. In the agreement the freelancers also stated that they would be responsible for paying their own social security, unemployment, and workers’ compensation taxes.
By treating those workers as independent contractors, Microsoft believed it could avoid the cost of providing benefits and paying employment taxes.
Microsoft made a very costly mistake. The company integrated the freelance programmers into its workforce. They worked on projects with regular employees, under the same supervisors, using the same supplies and equipment, during roughly the same hours, performing similar tasks, and on the company´s premises.
Microsoft believed that merely executing a formal agreement, in which the freelancers classified themselves as independent contractors, would insure the freelancers´ independent-contractor status.
The IRS, on the other hand, believed Microsoft was treating the freelancers as if they were employees. As a result of an IRS action, Microsoft agreed to pay all the freelancers´ back employment taxes plus penalties. But the company was in for an even bigger shock.
In 2000, the United States Court of Appeals, reviewing the case of Vizcaino vs. Microsoft, decided that since the freelancers were really employees, Microsoft should have provided them the same benefits that all regular employees enjoyed — including group health insurance and 401(k) plans. Now Microsoft must pay those freelancers millions of dollars in “back benefits.”
The rules for hiring and compensating independent contractors are not precisely defined or uniformly applied. The IRS might view your situation one way, and the National Labor Relations Board or the Wage and Hour Division of the Department of Labor might see it another way. And your state department of revenue might not agree with the feds.
Although the government doesn’t provide clear, concrete rules for distinguishing freelancers from employees, the guidelines given below will help. Be sure to consult your attorney and your accountant to formulate your hiring policy, and any work contracts, before you engage a freelance newsletter writer, editor or designer.
The most important test of whether a worker qualifies as an independent contractor is how much control he or she has over the methods and means used to accomplish the assignment. For example:
An IC should be paid by the job, upon submitting an invoice or series of invoices to the employer, and not according to a monthly or yearly salary. At the end of each year the employer should file Form 1099 for each IC who was paid at least $600 during the year.
The independent contractor usually has his or her own office that they operate out of, even if it’s little more than a desk and a phone in a spare bedroom. If you provide the IC regular desk space on your premises, the IRS might consider that worker your employee. Other considerations:
Some industries — including publishers, professional practitioners, consultants, and marketing firms — customarily hire freelance writers and designers more than other industries, and the IRS knows who they are. If your company is in any of those fields, you are more likely to convince the IRS that the ICs you hire are really not your employees.
If your company reports significantly more IC compensation than is standard in your industry, you’ll attract IRS attention.
As the Microsoft case illustrated, a written contract won’t guarantee a worker IC status if all the other factors point to a classification of employee. But getting an IC’s signature on a work-for-hire contract will help reinforce your efforts to comply with the rules. At the very least, such a contract should spell out the nature of the assignment, deadlines, compensation, and an acknowledgement of the worker’s IC status. Check with your attorney to see if other provisions are also necessary.
Alan G. Orlowsky, President of Orlowsky & Wilson, Ltd. in Lincolnshire, Illinois, has been counseling people on estate planning for 28 years. He previously worked for the IRS in its Estate and Gift Tax Division. He also worked for the Deloitte & Touche accounting firm, and he has taught taxation and accounting at Loyola University of Chicago, School of Business.
Al is a contributing author of the book 21st Century Wealth (Esperti Peterson Institute, Denver, 2000), and has written numerous articles on the subject of estate planning. Contact Alan Orlowsky by email or call 847-325-5559.
David M. Freedman is a Chicago-based writer, editor, and newsletter developer. He is the founder and director of Newsletter Strategy Session, a website for publishers of non-commercial newsletters.
Contact Dave by phone at 847-204-6848 or email at email@example.com