It is rare to find a CPA who understands the issues faced by online businesses. Today, we are lucky to have Dave Heistein, CPA, provide guidance on tax issues when hiring freelancers you need to keep in mind. Dave represents a number of online businesses, which means he brings real-world knowledge to the tax issues you face.
Richard A. Chapo, Esq.
As an online business owner, you probably make extensive use of independent contractors. The ability to hire someone to help you complete a myriad of business tasks such as web design and development, content creation, SEO, Adwords management and customer support is a godsend on the web.
Many online business owners prefer to hire independent contractors because it’s typically more affordable with less administrative work. Additionally, hiring independent contractors instead of W-2 employees can provide tax benefits to business owners. For example, using independent contractors may allow you to put more money into retirement and health benefit plans.
There are many sources for identifying and hiring independent contractors. These include full-service fee-based sites like Elance, oDesk, and Guru as well as do it yourself sites like Craigslist. For many online business owners, these sites have become the HR recruiting arm of their company.
While there are many benefits to hiring independent contractors, there are also some potential pitfalls you should be aware of. The IRS and many states have begun a witch hunt to identify businesses that improperly classify workers as 1099 independent contractors when they should really be classified as W-2 employees. The State of California can fine business owners as much as $5,000 per misclassified worker. Getting hit with a few of those hefty fines could be enough to bring a business down.
To help you avoid the pitfalls, I’ve provided some guidelines for properly classifying workers as well as some alternative hiring options. I also touch on IRS reporting requirements and tax issues when hiring freelancers when you are using sites such as Elance, oDesk or Craigslist.
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When you hire independent contractors, you do not need to pay payroll taxes or withhold income taxes but, you usually are responsible for issuing IRS income reporting forms. The full-service sites like Elance tend to offer buyers help in dealing with income tax reporting requirements, for example issuing form 1099-MISC for independent contractors hired through their site. Each site is operated a little differently, so it is worth spending a few minutes to understand their services and terms. Here are some highlights worth noting.
Elance and similar sites provide a service for connecting job posters and job seekers and charge a fee to the job poster. All providers are considered independent contractors and responsible for reporting their income and paying their income taxes. In general, form 1099-MISC is required if you have paid an independent contractor more than $600 within a calendar year. If form 1099-MISC is required, Elance will issue the form to help both you and the independent contractors you hire comply with the reporting requirements.
oDesk operates a little differently. It acts as a third party processor and also offers a payroll service. Due to oDesk’s classification as a third party processor, under the new Internal Revenue Code Section 6050W, it will provide form 1099-K to the IRS for any U.S.-based contractor paid over $20,000 USD on oDesk AND who logs over 200 separate oDesk transactions in a calendar year.
You, as the “employer”, are not required to submit any 1099 forms. This is a real benefit of using oDesk, especially if you plan to hire multiple independent contractors. Of course, it is important to make sure that you classify the worker appropriately and, as the relationship evolves, revisit the classification to ensure that your original classification is still the most appropriate.
Another option through oDesk, when the provider is more appropriately classified as an employee, is to use their oDesk Payroll service. With this service, the worker becomes an hourly employee of their staffing partner. Payroll taxes and income tax withholding are required, but these are managed through oDesk.
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Employee Leasing or Temporary Staffing
An alternative to the employee worker is employee leasing or temporary staffing through an agency. Advantages of this option include:
- agencies often provide employee benefits,
- agencies withhold all appropriate taxes and pay for FICA, worker’s compensation and unemployment insurance,
- there is no obligation to continue use of an individual worker, i.e., an unsatisfactory worker may be immediately replaced, and
- agencies are liable for claims for compensation by its employees.
When using employee leasing, the lines can become blurred regarding who is the employer. In some situations, the hiring company can be deemed a joint employer with the leasing agency. To avoid the risks and potential liability associated with being deemed a joint employer, it may be expedient to amend benefit plans such as severance plans or policies to specifically exclude all workers not on the payroll.
How To Determine Independent Contractor Status
Regardless of what site you use and what IRS form is required, it is important to ensure that you are accurately classifying your workers. In determining independent contractor status for IRS income tax reporting purposes, you must first determine if the worker is a U.S. person. A U.S. person is:
- An individual who is a U.S. citizen or a U.S. resident alien,
- A partnership, corporation, company or association created or organized in the United States or under the laws of the United States,
- An estate (other than a foreign estate), or
- A domestic trust (as defined in U.S. tax regulations).
The next thing you need to do is determine if the person being hired is an employee or an independent contractor. This is important as generally you must withhold income, Social Security, and Medicare taxes, and then pay them as well as unemployment tax on wages paid to an employee. This is not the case with an independent contractor. As mentioned above, there can be penalties for getting it wrong. If you erroneously classify an employee as an independent contractor, you may be held liable for employment taxes for that worker.
A key factor in determining if the person you hire is an independent contractor relates to the amount of control you have over the freelancer. If you have the right to control or direct only the result of the work and not what will be done and how it will be done, then the person is generally considered an independent contractor.
Here are some additional guidelines for making the independent contractor versus employee determination.
- Do you control or have the right to control what the worker does and how the worker does his or her job?
- Do you control or have the right to control business aspects of the worker’s job? (for example, how the worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
- Are you requiring or providing written contracts or employee type benefits (i.e. insurance, vacation pay, etc.)?
- Will the relationship continue and is the work performed a key aspect of the business?
You should look at all of these factors when determining whether a worker is an employee or independent contractor. The key is to look at the entire relationship and, if there is any gray area, make sure to document the process used in coming up with your final determination. And don’t forget to revisit this as the relationship evolves.
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If you go through the process and make the determination that the person you’re paying is an independent contractor, the first step is to have them complete Form W-9. [Request for Taxpayer Identification Number and Certification]
At tax time, you will be required to complete form 1099-MISC if you have paid an independent contractor more than $600 within a calendar year.
If you are thinking of utilizing a number of independent contractors or other options to the W-2 employee, your income tax reporting obligations should be one thing to keep in mind in the hiring decision. This approach may save money in the short run but hiring a number of independent contractors that are paid more than $600 can end up creating a lot of extra paperwork if you’re not careful. If you are hiring through a DIY site like Craigslist, just make sure to keep detailed records and know that if you hit the $600 mark, you will be required to submit form 1099-MISC.
Dave Heistein, CPA
About Dave Heistein
Dave Heistein is a Certified Public Accountant in the State of California, a QuickBooks Pro Advisor and managing partner of Profitwise Accounting. The Profitwise team includes experienced and knowledgeable bookkeepers, accountants, and business consultants familiar with the tax issues faced by online businesses and the steps necessary to best minimize the tax online businesses such as bloggers, e-commerce sites and affiliates face.
If you have any questions about income tax issues when hiring freelancers, feel free to give Dave a call (619-819-0252).