Many companies use independent contractors to slash payroll taxes and the high cost of fringe benefits. But using outside workers can result in other problems. It’s no secret that Uncle Sam wages battle with businesses over freelancers. And the situation is getting worse.
In recent years, many workers have turned to a career of consulting. The IRS is on the lookout for companies that use these consultants improperly — especially those that lay off workers and then hire them back as independent contractors to cut labor costs.
Tactics like that don’t go over well at the tax agency, so it published guidelines on how auditors should analyze consultants and independent contractors. Often, an audit of the worker means the companies that hire them are also scrutinized by the IRS.
If your independent contractors are legitimately independent, there’s no problem. But if they’re employees in disguise, the IRS can “reclassify” them as employees and you’re slapped with hefty bills for back taxes, plus interest and penalties. And audits by state agencies are also common and frequently occur when freelancers apply for unemployment compensation.
Your company’s pension plan isn’t immune either. As independent contractors, workers are generally excluded from retirement plan contributions. If the IRS reclassifies them, your company may be penalized and your qualified plan might be disqualified.
To stay on the safe side, consult with your tax advisor and make sure freelancers sign contracts that specify:
They aren’t employees for federal income tax purposes and are responsible for paying their own Social Security and Medicare taxes.
They aren’t entitled to employee benefits and are not covered by workers’ compensation.
Have your regular employees sign contracts, too. By varying the two types of documents, you can make the case that both categories of employees perform different tasks.
Here are four more tips to safeguard your company:
- Consistently treat all workers performing similar tasks as either independent contractors or employees. If contractors must wear ID badges or use company vehicles, make sure their contracts explain why. For example, the policy was instituted after customers expressed safety concerns about deliveries in unmarked cars.
- Give outside workers considerable discretion about how and when they perform their duties. In general, independent contractors must control the way they get the job done.
- Send each contractor a Form 1099 showing non-employee income if you pay $600 or more in a calendar year.
- Don’t supply freelancers with services you give employees. Some companies have run into trouble with the IRS for providing contractors with office space, computers, cars and other perks. Independents generally furnish their own tools and materials.
So what if you do rehire some laid-off employees as independent contractors? It’s difficult — but still possible — to classify them as contractors. But don’t let freelancers work in your office and give them new titles. For example, your retained employees might be staff representatives while your new workers are outside service agents.
There’s nothing illegal about rehiring former workers as freelancers. You just have to make sure you structure the deals properly so the IRS doesn’t question you and reclassify them.