Let's say you decide to onboard a freelancer, also known as 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
The reason you don't have to worry about withholding is that freelancers are considered to be self-employed, meaning they must calculate and pay their own tax responsibilities. However, you can deduct payments that you make to freelancers as a business expense for your company, giving you an opportunity to reduce your business's taxable income.
What to expect when you hire an employee
When you hire an employee, you are required to withhold both federal and state-level income taxes. The same is required for Social Security and Medicare. This money is taken out of the employees' 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.
Last but not least, as an employer, it is highly likely that you extend health insurance and retirement plan options to your employees. While these benefits positively impact them, they also yield favorable effects for 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 offer stability and loyalty.
But employees add an administrative burden in 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 properly 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 as a way to reduce your business expenses, hiring them isn't a means of avoiding legal responsibilities.
At the same time, keep in mind that the IRS pays attention to how you classify the people who work for you. The misclassification of those who do 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 that you will face if you are caught misclassifying workers will depend on whether the IRS and the Department of Labor believe that 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
- 0.5% of your unpaid tax liability up to 25% for each month
The government does not take the misclassification of employees lightly, which makes sense when you recognize that underreported tax liabilities account for approximately 80% of the country's gross tax gap.
All in all, it's important 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.
At the end of the day, your business finances will be influenced by your decision to either onboard freelancers or hire employees, especially because of the tax implications that each option carries. If you aren't sure which path is the best route to take for your business, reach out to a tax professional or an accountant who can help you navigate these complexities.