Let’s say you decide to onboard a freelancer, an independent contractor. What should your next tax- and finance-related moves be?
Let’s find out!
What to expect when you onboard a freelancer or an independent contractor.
When paying freelancers, you are not required to withhold any of the following from those payments:
- Federal taxes
- State income taxes
- Social Security
- Medicare
You don’t have to worry about withholding because freelancers are self-employed, meaning they must calculate and pay their tax responsibilities. However, you can deduct payments you make to freelancers as a business expense for your company, reducing your business’s taxable income.
What to expect when you hire an employee.
When you hire an employee, you must withhold federal and state-level income taxes. The same is required for Social Security and Medicare. This money is taken out of the employee’s paychecks.
In addition to withholding taxes from your employees, you’ll be responsible for paying your portion of Social Security and Medicare taxes as an employer, which equates to 7.65% per employee.
Finally, as an employer, you likely extend your employees’ health insurance and retirement plan options. While these benefits positively impact them, they also affect your business because you can deduct these expenses from your taxable income.
What to consider before bringing on anyone.
When deciding between a freelancer and an employee, the nature of the work comes into play: Highly specialized or short-term projects may be better suited for freelancers, while long-term, core business functions usually require employees.
Freelancers offer lower upfront costs because you avoid employer taxes and benefit expenses. Employees can provide stability and loyalty.
However, employees add an administrative burden to managing payroll and tax withholding, which can be more complex and time-consuming than working with freelancers.
And what about your company’s long-term goals? Hiring employees may provide greater control over and consistency among your workforce.
The importance of correctly classifying your workers.
If you misclassify your employees as freelancers or vice versa, you could open the door to penalties that will complicate matters with your business, not to mention your business’s relationship with the IRS. So, while independent contractors can serve to reduce your business expenses, hiring them isn’t a means of avoiding legal responsibilities.
At the same time, remember that the IRS pays attention to how you classify the people who work for you. The misclassification of those who work for you can result in costly outcomes, ranging from expensive penalties to time-consuming lawsuits or even jail time in serious cases.
What classifies someone as an employee?
As defined by the IRS, a W-2 employee is someone whose work is controlled by you, meaning you dictate what they do and when they must do it. On the other hand, a 1099 freelancer is someone who decides when and how they perform their work-related duties.
Penalties for misclassifying workers.
The intensity of the penalties you will face if you misclassify workers will depend on whether the IRS and the Department of Labor believe you made the error on purpose or by accident.
That said, here are some penalties you might face:
- $50 for each W-2 you fail to file correctly,
- 1.5% of your wages,
- 40% of any FICA taxes that you didn’t withhold from employees and
- 0.5% of your unpaid tax liability up to 25% each month.
The government does not take employee misclassification lightly, which makes sense, considering that underreported tax liabilities account for approximately 80% of the country’s gross tax gap.
All in all, it’s essential to understand the difference between a W-2 employee and a 1099 freelancer, not only to avoid penalties but also because you can benefit from financial perks for your business.
Your business finances will be influenced by your decision to either onboard freelancers or hire employees, mainly because of the tax implications that each option carries. If you aren’t sure which path is best for your business, contact us at Lang Allan CPA, who can help you navigate these complexities.