Government Tax Requirements for Contractors

October 14, 1998
Notes by Henry Robb

Ed Milber, CPA, and Andrew Davis, principal, Synergistech Communications, discussed what legally distinguishes independent contractors from employees, how to safeguard one's freelance status, and how to keep the IRS at bay.

Milber and Davis examined various factors in a business relationship that determine, in the eyes of the IRS, whether an individual is an independent contractor or an employee. This is a particularly relevant issue now because as companies are moving toward hiring more subcontractors to reduce expenses, the IRS, not wanting to be left out of the action, is clamping down on companies who hire subcontractors. Specifically, if the IRS determines that an independent contractor is an employee, the IRS hits the company for back taxes and assesses penalties. The IRS also recategorizes the freelancer as an employee with that company, effectively ending that working relationship. It is, thus, extremely important for freelancers to safeguard their freelance status and to educate their clients, if necessary, on how best to do this.

Milber handed out a 27-page document, "Independent Contractor or Employee," and defined "independent contractor" for us this way: "An individual is an independent contractor if the payer has the right to control or direct only the result of the work and not the means and methods of accomplishing the result." That is, a client can tell an independent contractor what to do but not how to do it. Financial control is also important: A client should not be paying a freelancer's insurance directly to his or her insurer, for example. Actually, independent contractors usually have their own insurance. They also tend to have more than one client, have more unreimbursed business expenses than employees, work out of their own homes, and own their own equipment.

Miller also mentioned some of the financial disadvantages of being a freelancer. Independent contractors pay double the social security tax of company employees, generally pay for all of their own insurance, and do not receive any company benefits. Though incorporating oneself can be helpful, how helpful depends on how much one makes. Incorporating is expensive: one must pay both personal taxes and corporate taxes and $800 a year to the franchise board. Moreover, in order for incorporating to be worthwhile, a freelancer should make at least $70,000 a year in gross revenues. Milber advises independent contractors who make between $30,000 and $60,000 a year to deduct all their expenses and hold on to their receipts. He added that almost everything is deductible-even meals, if one takes out a client.

Andrew Davis spoke about how to safeguard one's status as an independent contractor and how risky it can be not to. Davis's handout listed the 20 questions California's Employment Development Department (EDD) uses to determine if a person is really an independent contractor. The first, and perhaps most important, is "Are you required to comply with instructions about when, where, and how the work is to be done?" Again, you are an employee if the person you work for has the right to direct or control the way you work.

Davis mentioned some other things a freelancer needs to be careful about. First, if a client gives you special software to use for a job, it's best to learn the software on your own time and not bill the client. If you do bill the client, then technically the client is underwriting your training, and that makes you look more like an employee. It is best, too, if you remove the client'a software from your computer after the project. Davis also suggested billing for an entire project (or sections), rather than by the hour or day.

Many companies have become aware that they need to protect themselves against an audit in which the IRS decides that some of the company's independent contractors are actually employees. One way for freelancers to help is to encourage them to amend contracts. For example, if a contract says that a client can terminate an independent contractor at will, the contractor looks like an employee. Better: "termination will be decided by mutual consent."

Davis emphasized that educating clients about the importance of contracts is part of "client management." A contract not only protects the company, it protects the freelancer by securing freelancer status and ensuring payment.