Armanino Blog

Why "Freelancer" Is an F-Word

by Jenn McCabe
September 29, 2017

If you say "freelancer" to me when referencing your staff, my eyebrows will go up through my bangs in alarm. That's because using freelancer or "outside consultant" terminology will raise IRS, DOL or other government entities' suspicions about your worker classification. It will also be a red flag for a potential buyer's due diligence auditor if you are selling your company.

These aren't situations you want to be in, particularly if you don't have the deep pockets of an Uber. (Some states, including California, have argued that Uber drivers are staff. I'll go on record here and disagree; I think those drivers are the embodiment of entrepreneurialism.) When a government auditor rules against an employer, they charge back taxes and interest. Penalties of anywhere from $5,000-$25,000 per violation (!) are also assessed, depending on whether the employer's circumvention of the rules was innocent or intended. In a due diligence audit, the buyer will discount the price, or at least insist on a bigger escrow, if you have done a poor job of mitigating your misclassification risk.

It's our job to protect you from this kind of scrutiny and exposure. So we are encouraging our clients to avoid the f-word and instead say "vendor" or "service provider." If that vocabulary feels impersonal or too distant from the truth of your relationship, those workers may need to be classified as temporary employees.

I can hear your wheels turning. You're saying, "But they use their own stuff and their own office..." or "they work at other shops like mine, too." These days many employees work remotely, so that test doesn't hold true anymore. And if someone says they "freelance" at other shops, ask them if they are given a W-4 to fill out, and if taxes are withheld from their pay. They will often say yes.

Staff or independent contractor?

So how do you decide how to classify a worker? It can be confusing. Several decades ago, the IRS created a 20-question test to determine whether a worker fit the 1099 classification. That test is now outdated in some states: It allows for more subjective decision-making than local labor rules allow. In California, the rules say that if a role is "usual and necessary," it's a staff position. For example, if you hire a copywriter at an ad agency, they should go on staff because that's a standard position at an agency.

To stay out of trouble, have your team ask vendors these questions UP FRONT:

  1. Do they have a federal employer identification number (FEIN) and not just a social security number (SSN)?
  2. Do they have the right to exert control on the overall relationship and work details?
  3. Do they work from their own office and use their own equipment?
  4. Will they bill you for a project fee, as opposed to hourly or daily billing?
  5. Do they have a business license?
  6. Can they show evidence that they carry their own general liability and worker's comp insurance? (If not, you have to cover them, so you may as well put them on staff.)

If the answers are predominantly "NO", or if it's not perfectly clear, err on the conservative side and put the person on payroll as "temporary staff." They'll be ineligible for benefits.

If you get all "YES" answers, it's a good indication that it is okay to proceed and get a W-9. That said, it's still a very gray area. So we recommend using some additional criteria to decide whether it's safe to pay someone as a vendor instead of putting them on payroll.<

We are comfortable classifying a worker as an independent contractor if they:

  • Are an LLC or an S-Corp, so the W-9 they provide has a taxpayer ID, not their SSN
  • Have their own staff, or can subcontract the work you give them to another worker
  • Have other clients and don't work full time for you
  • Provide a high level of skill, in a specialized field, and the high level of pay they receive makes that clear
  • Give you a contract with a Statement of Work (SOW), thereby showing "control" of the work relationship.

Also ask the vendor for their business license, website, insurance certificates and a contract―before you pay them. If you have to provide the contract, or an Independent Contractor Agreement (ICA), make sure the dates are not open-ended. Each contractor should be "short term" or "defined term." Get a good template for the ICA that has all the recommended protective language.

Triggers for an audit

There are a lot of things that can trigger an audit. We see employers getting flagged for review when a worker files for unemployment benefits, even by accident, or gets hurt or sick on the job and files for disability or workers comp. If someone is angry because they got paid late, or insists that they are eligible for sick pay or overtime, they may also file a complaint with HR, an attorney, or the state labor board or employment department.

The risk is high because it's easy to get snared. Auditors will call your 1099 recipients and ask them the questions above, and you have no control over their answers or context. If one 1099 recipient raises a ruckus, all your 1099s are reviewed for up to three years.

Taking time to vet your workers will help you avoid misclassification. If you do get mail from the IRS or the state about a claim filed by a "freelancer," be sure you answer it sounding like a client, not a boss. And remember―do not use that f-word.

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Jenn McCabe - Partner, Outsource HR - El Segundo CA | Armanino
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