Independent contractors, also known as freelance employees, are individuals who work on their own, without a long-term contractual commitment to any one employer. An independent contractor usually performs services or completes work assignments under short-term contracts with several employers, or clients, who have the right to control only the final result of the individual's work, rather than the specific means used to get the work done. Examples of positions held by independent contractors range from doctors and computer programmers to maids and farm workers. Freelance employment can offer a number of advantages to individuals, including flexible work arrangements, independence, variety, and some tax deductions. It can also hold some pitfalls, however, such as assuming risk in business dealings, paying self-employment taxes, and taking personal responsibility for health insurance, disability, and retirement coverage.
Specifically, individuals who are classified as independent contractors can deduct work-related expenses for tax purposes. In contrast, the first 2 percent of expenses are not deductible for those classified as employees, plus the deduction is phased out above $55,900 in income. In addition, independent contractors often qualify for tax deductions for using part of their home as an office and for salaries paid to other people, while employees usually do not. Independent contractors also have the benefit of sheltering 15 percent of their annual income, or up to $30,000, for retirement, while employees are limited to $9,500 annually. Finally, independent contractors must pay the full amount of Social Security and Medicare taxes and make quarterly estimated tax payments to the federal government. Employers must withhold taxes for their employees and pay half of their Social Security and Medicare taxes.
Freelance employment boomed in the United States during the 1980s, as many companies sought to reduce their payroll costs in order to remain competitive. Instead of hiring new employees and paying an additional 30 percent or more in payroll taxes and benefits, many companies chose to make "work-for-hire" arrangements with independent contractors. Businesses, and especially small businesses, can gain several advantages from such arrangements. For example, employers are not responsible for paying taxes for independent contractors, and they avoid the high costs of providing health insurance, paid vacation and sick leave, and other benefits often granted to regular, full-time employees. Instead, employers simply file Form 1099 with the government to report the total compensation paid to each independent contractor for the year.
The boom in freelance employment led to increased scrutiny by the U.S. Internal Revenue Service (IRS) in the early 1990s. Section 1706 of the Internal Revenue Code provides a 20-part test to determine whether workers are employees or independent contractors. The IRS began using this test to reclassify many independent contractors—particularly those engaged in high-paying professions—as employees in order to eliminate tax deductions and increase tax revenues. This practice "leaves virtually everyone angry, and that includes the IRS," according to David Cay Johnston in the New York Times. "The agency is trying to apply tax laws that were largely written for an age of manual work and factories to an era of intellectual labor, often conducted in home offices." The IRS would argue that the law also protects individuals from unfair treatment by employers—such as being fired and then rehired as an independent contractor without benefits—but few of the reclassifications have involved exploited low-wage laborers, because they generate minimal tax revenues. Since the issue could potentially affect up to 5 million self-employed Americans, Johnston called it "the most contentious employment tax issue in the nation today."
Although the controversy surrounding freelance employment has received increased attention in recent years, it is not new. As early as the 1960s, the IRS started looking more closely at household employees—such as maids, nannies, and gardeners—who often received income "under the table" and thus did not pay taxes. The main cause of dissention over current application of the law, according to the New York Times, is that it often tends to penalize individuals who wish to be classified as independent contractors and take advantage of tax breaks (as well as the small businesses that depend on them), while it often fails to protect individuals who should be classified as employees and be eligible for benefits. For example, the IRS would be likely to review the case of a highly paid engineer who markets her services to several companies as an independent contractor and deducts various expenses of doing business. But the IRS would be unlikely to review the case of a migrant farm wQrker who is employed by a large producer but, as an independent contractor, makes less than minimum wage and receives no disability or old-age benefits.
The IRS applies a 20-part test in order to determine whether a certain worker should be classified as an employee or an independent contractor. The main issue underpinning the test is who sets the work rules: employees must follow rules set by their bosses, while independent contractors set their own rules. The hours during which a job is performed is one determination of work rules. For example, if the employer dictates an individual's work hours or pays an individual by the hour rather than by the job, that individual is likely to be considered an employee rather than an independent contractor. Likewise, if the employer requires that an individual work full-time or not be employed by another company simultaneously, that individual would appear to be an employee. On the other hand, an individual who sets his own hours, receives payment by the job, and divides his time between work for several different employers would probably be classified as an independent contractor.
Other criteria involve who provides the tools and materials needed to complete the work. For example, an individual who works at an employer's facility and uses the employer's equipment would be considered an employee, while one who works at a separate location and provides her own equipment would be classified as an independent contractor. Another element of the IRS test involves termination of the work relationship. Employees can usually quit their jobs at will, and can also be fired by their employers. An independent contractor, however, would have a contractual obligation to complete a specific amount of work for an employer, and neither party could break the agreement without cause. Finally, an independent contractor usually pays his own expenses of doing business and takes the risk of not receiving payment when work is not completed in accordance with a contract, while an employee is usually reimbursed for businessrelated expenses by the employer and receives a paycheck whether his work is completed or not.
Despite such specific guidelines, the IRS test has generated criticism. "This 20-factor test has frustrated both the IRS and the small-business owner," said an accountant quoted in Crain's Small Business Detroit. "Ten different revenue agents could review the same case, and ten different responses could result." The IRS recognized that the test was sometimes applied inconsistently, and was evaluating whether to modify or eliminate it. But while a 1998 U.S. News and World Report article noted that the agency has "mellowed in the last couple of years (legislative pressure helped)," the IRS still tries to reclassify certain independent contractors as employees because of the potential gains in tax revenue. Reclassification can cost businesses that rely on independent contractors huge sums in penalties, back taxes, and interest—and can even force some out of business.
The rules governing independent contractors affect small businesses in two significant ways. First, many entrepreneurs are themselves independent contractors, and they must understand and adhere to the IRS guidelines in offering services to clients. Otherwise, they risk being reclassified by the IRS. An entrepreneur who is reclassified as an employee of a major client loses a variety of tax breaks and other advantages of self-employment.
In order to be considered independent contractors, entrepreneurs must establish that they are in business for themselves for the purpose of making a profit. They might demonstrate that their enterprise is a business—rather than a hobby or the work of an employee—by registering a business name, obtaining an occupational permit or license, establishing an office, soliciting clients, and printing stationery and business cards. Even if the majority of work will be performed for one client, entrepreneurs should make clear their intention of soliciting work from other clients.
Next, the entrepreneur should subject his or her business activities to the IRS 20-step test in order to avoid the appearance of being an employee. For example, the entrepreneur should be certain that the client does not set his or her hours, determine the location where work is performed, pay withholding taxes on his or her income, or provide needed equipment, tools, supplies, or transportation. Instead, the entrepreneur should sign a contract specifying an amount of work that will be completed by a certain deadline. The contract should include a specific disclaimer stating that this work will be performed as an independent contractor. For tax purposes, the entrepreneur should also be certain to obtain from the client a 1099 form (a statement of miscellaneous income), rather than a W-2 form (a statement of income from employment).
The rules governing independent contractors affect small businesses in another significant way. Many small businesses lack the resources to hire permanent employees to provide support for short-term projects or to provide expertise in highly technical fields, so instead they enlist the services of independent contractors. In these cases, it is to the benefit of the small business owner as well as the independent contractor to spell out the details of the work arrangement in a contract. Small business owners should also choose independent contractors carefully to be sure that they present themselves as in business to make a profit.
[ Laurie Collier Hillstrom ]
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