AcctTwo Blog

Freelancers vs. employees: A key distinction for SMBs

February 05, 2016
Posted by: David Furth

Category: How To's, Accounting

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If you're a small or medium-sized business leader, then there's no getting around the need to hire personnel. It's one of the most important responsibilities you'll face, since a company is only as good as its employees. To thrive, you need to choose the right candidates for every position.

But it's not just a question of finding the ideal person for each job - there are a lot of other considerations, as well. One of the most important of these: Choosing between employees and freelancers. This has major implications for SMB tax filing, and the wrong approach can lead to devastating consequences.

With that in mind, here's a quick overview of the differences between hiring personnel as employees and freelancers, and how to make the right choices for your company.

The new normal
This issue has become much more complicated in recent years. In the past, it was usually quite easy to determine the difference between a full-time employee and a freelancer or independent contractor, based on nothing more than the job title and associated responsibilities.

That was before the onset of the part-time economy. Now, it's become much more common for people to offer their services to companies in a less rigid or formalized way. Individuals are working from home and setting their own hours, and businesses are looking for workers who fulfill specific project needs on a case-by-case basis.

There are advantages and disadvantages to both the more traditional approach to employees and the more recent move toward a greater reliance on part-time workers. We're not going to get into that debate to too great a degree here. For now, the bigger question is how business leaders can make sure they classify their workers correctly.

Dangerous consequences
The issue at hand isn't choosing the most advantageous classification. That may be tempting, but the reality is that the risk isn't worth the reward. As Business News Daily Assistant Editor Nicole Fallon Taylor pointed out, Microsoft ran into this problem in the 1990s, when the company classified many of its engineers and programmers as independent contractors. This led to legal action and Microsoft was ultimately forced to pay out millions of dollars in fees and penalties.

"Microsoft paid millions of dollars in fees and penalties due to employee misclassification."

What's more, tax attorney Jay Child told Taylor that the IRS and state governments are looking more closely for signs that companies are misclassifying their workers on their tax returns - a point echoed by accountant Michael Greenwald in a conversation with the Charlotte Observer.

Understanding the difference
So what is the difference between contract workers and full-time employees? Taylor highlighted the most important factors to consider.

One of the most obvious issues: compensation. Taylor noted that if you pay a worker an ongoing salary, then the IRS is probably going to consider and classify that person as an employee. If, on the other hand, you pay by the project, that person is probably a part-time worker.

Equipment is another consideration. If the workers are using software, hardware or other gear that your company owns, that suggests the individuals are employees, rather than independent contractors who relies on their own equipment, the writer explained.

Does the worker use your equipment or his/her own?Does the worker use your equipment or his/her own?

One more issue that needs to be taken into account when determining whether a given worker is a full-time employee or part-time is exclusivity, Taylor asserted. If you're asking someone to work for you and only you, then you've pretty much got an employee on your hands. Independent contractors reserve the right to offer their services to others.

The right steps
Once you've got this classification system straightened out, it's critical that you take the right steps to abide by the appropriate accounting and tax regulations.

Perhaps most importantly, you need to distribute the right tax forms to your workers. Regular employees need W-2s and freelancers need 1099s, and in both cases you need to accurately detail all yearly compensation. As the Charlotte Observer pointed out, the IRS will compare the 1099s it receives with your reported income, so it's imperative that these numbers match up.

And, of course, there are certain obligations that employers need to provide for their full-time employees - most notably, Social Security and Medicare taxes, along with providing health insurance. Your accounting solution needs to have records of all of this.

By classifying your workers correctly from the get-go, you'll be able to avoid all of the accounting and tax issues that have bedeviled so many other companies. Your workers will receive the compensation and overall treatment they are entitled to and you won't have to worry about any ambiguity with your tax filings. This will make your SMB function more smoothly and efficiently, regardless of whether you depend on full-time employees, independent contractors or some combination of the two.