Things get legally tricky when it comes to freelancers and independent contractors. Here’s what you need to know to stay compliant with the law.
Here's what you need to know:
- Just because you have an agreement with a freelancer saying they’re an independent contractor rather than an employee doesn’t necessarily make it so
- Both the Internal Revenue Service and the Department of Labor’s Wage and Hour Division have issued extensive guidance on the difference between contractors and employees
- Many of the differentiating rules come down to behavioral control, financial control, and relationship control of the work
- It’s recommended to either define an internal role for tracking legal compliance issues like these or hire a firm that specializes in them
The gig economy was already on the rise. Then COVID hit and it exploded. The gig economy — work in the form of short-term, often freelance contracts rather than permanent jobs — increased by more than 30%.
For workers, this means increased flexibility and the diversification of a paycheck. Losing one client — even a major client — isn’t as devastating as being laid off from your one and only job.
Plus, there are perks like working from wherever you want, whether that’s at home or at the beach.
Companies benefit, too. Having employees means following employment law that requires offerings like healthcare, paying Social Security taxes, and the like. If your company is composed of a bunch of independent contractors rather than employees, it can be a financially beneficial endeavor.
This has led to the rise of “permalancing” — freelancers who largely work for just one company and nearly full-time.
Things get legally tricky when it comes to permalancers. Just because you have an agreement with a freelancer saying they’re an independent contractor rather than an employee doesn’t necessarily make it so.
Even if the contract is a temporary one that’s designed to lead to full-time regular employment, it can still be against the law.
Want to make sure you’re following the law but not sure where to start? Wondering what the consequences are of hiring someone as a contractor if they’re technically supposed to be an employee? Read on for a crash course in whether or not your permalancer is actually an employee.
How the IRS determines contractor versus employee status
Both the Internal Revenue Service and the Department of Labor’s Wage and Hour Division have issued extensive guidance on the difference between contractors and employees. The best place to start is by reading up on the federal guidance shared by these agencies.
The IRS offers the following common law rules that are designed to differentiate between contractors and employees:
- Behavioral control: Does the worker control how they do their job or does the company set the parameters?
- Financial control: Does the worker control the business aspects of their job? Or is the company in charge of determining things like how the worker is paid, whether or not expenses are reimbursed, and who provides the necessary tools and supplies?
- Relationship control: Is the work governed by written contracts? Or are there elements like benefits and an ongoing relationship that dictate the work?
The 1st parts of these elements lend themselves to a true contractor relationship. The worker controls how, when, and where they work.
In a true contractor relationship, the worker controls how, when, and where they work.
The worker determines how the work gets done, with everything from payment to supplies. The work is performed as a result of a contract that has an end to it.
The second parts speak to an employer-employee relationship. If a company is telling the worker where, when, and how to work and dictates the supplies and equipment used, it’s likely an employment relationship.
If the company dictates payment terms and the working relationship is indefinite, it’s likely that the worker is actually an employee.
How the Department of Labor determines contractor versus employee status
In October, the Department of Labor published a Notice of Proposed Rule Making (an NPRM) on the difference between employees and contractors. This is essentially a proposed change to what’s already on the books.
Should this change go through, the Department of Labor would outline the difference between a contractor in terms of 2 core aspects. These aspects are control and the opportunity for profit or loss.
However, right now the Department of Labor defers to the courts to determine whether or not a worker is an employee or a contractor. These decisions span factors like:
- The extent to which a freelancer’s services are an integral part of a company’s business. If you’re using a ton of permalancers to do ongoing work that is at the core of what your business does, you may be misclassifying them.
- The degree of permanency of the working relationship. If the working relationship is indefinite rather than confined to a certain amount of time as defined by a contract, you may be misclassifying them.
- The amount of investment a contractor has in facility and equipment. True freelancers who do work for multiple clients invest in the tools — hardware, software, and otherwise — that they need to run their business.
- The nature and degree of control by the company. This is largely what the IRS has outlined. Does your freelancer make their own business decisions? Or do you, the company, tell them when they’ll get paid, how they’ll get paid, and the like?
- A contractor’s opportunity for profit and loss. This has become fairly central to the Department of Labor’s classification. True freelancers reap the profits and suffer the losses of their business. But if that’s replaced with a steady paycheck by your company and only your company, you may have misclassified them.
What to do if you’ve misclassified an employee as a contractor
If you’ve realized that you’ve misclassified some workers as contractors, the next thing you’ll want to do is remedy the situation. The safe bet is to start treating the contractor as an employee immediately. It’s a better-safe-than-sorry strategy.
Workers who feel that they’ve been misclassified as a contractor rather than an employee can go to the IRS. If they’re successful in their inquiry, your business can be on the hook for the employer’s half of Social Security and Medicare back taxes and more.
It all goes back to the local, state, and federal penalties for violating wage, tax, and employment law.
If you’re truly not sure what a worker’s classification should be, there’s an IRS form for that. Both workers and employers can fill out and submit Form SS-8 to the IRS for a determination on a worker’s correct employment status.
How to stay on the legal up and up moving forward
Not every company misclassifies workers out of a malicious desire to boost profit at their workers’ expense. Jobs change over time and sometimes it’s as simple as not staying on top of changes as your company grows.
Either define an internal role for tracking legal compliance issues like these or hire a firm that specializes in them. The cost might seem daunting, but it’s nothing compared to the cost and hassle of dealing with a federal agency that’s found out you’re misclassifying workers.
Employers of Record are essential 3rd-party companies that hire workers and deal with the legal side of things. They do this while their employees do work at other companies like yours.
Of course, there are some major downsides to an approach like this. You have little control over how your workers are treated by their true employer. Plus, you’ll have to follow the Employer of Record’s rules for engaging with their employees. It’s not ideal, but it is one available solution.
One of the best ways to handle this is to strive to be the best employer you can be. Treat your workers right and don’t short them on the employee benefits they’re entitled to.
Making these investments upfront will help ensure that you have a functional and legally compliant company as you scale over time. Being an employer isn’t always easy. However, once you have the hang of things like this it’s easy to stay compliant in the future.