Freelancer or Employee? Proper Classification Is Key to Avoid Tax Headaches

When small business owners grow their business, they may suddenly find that they're working with three, then six, then perhaps half a dozen freelancers and consultants. Or maybe the business owner has a few employees and relies on freelancers to fill the gaps, or to staff for peak times. It's a smart strategy for building a young company — but distinguishing between employees and freelancers can be a tax and compliance minefield.

If the lines become blurred among full-time employees and freelancers — for example, they all work together in the same space and use office computers — the situation can quickly become complicated (and costly). The business could be liable for payroll taxes for people it considered consultants, or freelancers could insist on healthcare and other benefits.

Fortunately, you can take some easy steps to vet consultants to make sure they won' be classified as employees — and establish processes that clearly define how freelancers interact with employees.

Hire Consultants With Business Licenses or Who are Incorporated

This gives you some assurance that the freelancer is operating a “real” business and has the paperwork to prove it. Not every freelancer will have incorporated their businesses, but you can certainly require that freelancers obtain business licenses from their local cities or counties.

Ask Freelancers to Sign a Contract

A contract can help you spell out the terms of a freelancer engagement, including the specifics of the project, the deliverables the freelancer will create, deadlines and payment. The contract can also spell out the fact that the freelancer is not an employee, and therefore isn't entitled to employee benefits. Here's a helpful list of items to include in a freelancer contract. Your lawyer can also draw up a boilerplate agreement that you can modify as needed for different projects.

Give up Some Control

One habit that can encourage tax authorities to scrutinize your use of freelancers is controlling how, when and where they work. Don't invite freelancers to work at the office unless the project requires it, such as for key meetings. You also should not dictate the freelancer's working hours, provide them with a business title or give them access to employee handbooks. And while this may be hard for a small business owner, you also shouldn't supervise a freelancer in the same way you would an employee (e.g., checking in daily). The freelancer should work independently, delivering projects according to the terms and guidelines of the contract.

Don't Demand Exclusivity

The more hours a freelancer works for you, the more likely they might be classified as an employee. Obviously, some short-term projects may need freelancers on hand full-time for a designated period — but the start and end dates should be spelled out in a contract or statement of work.

Pay Freelancers When They Send You an Invoice

Don't pay them on the same schedule on which you pay regular employees. The impetus is on freelancers, suppliers and other external contractors to request payment.

The IRS offers some useful guidelines on employee classification challenges, and breaks down classification issues by behavior (how the worker is managed), financial (how the worker is paid) and type of relationship (existence of contracts). It's worth a read so you can match your current practices against IRS advice.

Christine Kent brings over 20 years of writing and journalism expertise to her work for technology, consumer and corporate organizations. Her journalism-driven approach enables her to not just write a document, but to find the voice of a client to tell their story in the most compelling way.