Free-lance employees, also known as independent contractors, are individuals who work on their own, without a long-term contractual commitment to any one employer. A free-lance employee 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. Free-lance 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.
Free-lance 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 free-lance employees, 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. In addition, employers that use independent contractors relieve themselves of the risk of costly litigation over hiring, promotion, firing, and other employment practices. These employers simply file Form 1099 with the government to report the total compensation paid to each independent contractor for the year.
The boom in free-lance 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."
But the IRS has made reclassification of independent contractors a priority, since fraudulent IC arrangements are estimated to cost the government between $6 and $20 billion per year in tax revenue. The IRS would also argue that they are attempting to protect 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 8.5 million self-employed Americans—or roughly 7 percent of the overall workforce—Johnston called it "the most contentious employment tax issue in the nation today."
Although the controversy surrounding free-lance 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. However, the IRS would be unlikely to review the case of a migrant farm worker 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. However, a free-lance employee 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 business-related 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. However, the agency had no plans to reduce its efforts to reclassify certain independent contractors as employees because of the potential gains in tax revenue. Reclassification can cost small businesses that rely on free-lance employees huge sums in penalties, back taxes, and interest—and can even force some out of business. In Michigan alone, the IRS reclassified 51,000 independent contractors in 1993 and assessed a total of $100 million in back taxes. In 1997, however, the IRS agreed to provide amnesty for businesses that had erroneously classified workers as independent contractors when they were in fact employees. Those businesses that come forward, admit their mistake, and agree to treat affected workers as full-time employees in the future are not penalized for their past actions.
The rules governing independent contractors affect small businesses in two significant ways. First, many entrepreneurs are themselves free-lance employees, and they must understand and adhere to the IRS guidelines in offering services to clients. Otherwise, they risk falling into what Robert Laurance called "the employee trap" in his book Going Free-Lance. 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. The entrepreneur should also be certain to obtain a 1099 form (a statement of miscellaneous income) from the client for tax purposes, 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. The small business owner should also choose free-lance employees carefully to be sure that they present themselves as being in business to make a profit.
Bordwin, Milton. "Independent Contractors: Savings or Legal Snare?" Management Review. November 1995.
Brodsky, Ruthan, and Marsha Stopa. "Sneak a Tax." Crain's Small Business Detroit. July 1994.
"Employee vs. Independent Contractor." IRS Publication No.937. Washington, D.C.: Internal Revenue Service, 1994.
Hand, Larry E. Freelancing Made Simple. New York: Doubleday, 1995.
Johnston, David Cay. "Are You Your Own Boss? Only if the IRS Says So." New York Times. March 19, 1995.
Laurance, Robert. Going Free-Lance: A Guide for Professionals. New York: Wiley, 1988.
Luciano, Lani, et al. "A Guide to Going Solo." Money. September 1998.
Russman, Joel, and Cindy Gomerdinger. "Pros and Cons of Contractors vs. Employees." Denver Business Journal. March 17, 2000.
Spragins, Ellyn E. "Protecting Independent Contractor Status." Inc. March 1992.
Wolfe, Michael N. "That's Not an Employee, That's an Independent Contractor." Compensation and Benefits Review. July-August 1996.
Comment about this article, ask questions, or add new information about this topic: