Free-Lance Employment/Independent Contractors

ELEMENTS OF THE IRS TEST

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 her own hours, receives payment by the job, and divides her 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 his 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.

FREE-LANCE EMPLOYMENT AND SMALL BUSINESSES

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 being reclassified as an employee of their client in an IRS audit of the same. 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.

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