Who Can I Hire As A 1099 Contractor?
Copyright 2010 by Morris Rosenthal - - contact info
Copyright 2010 by Morris Rosenthal
All Rights Reserved
Tax Deduction for Hiring Self Employed Freelancers and Contract Help
Warning: These pages are not intended as professional advice. They are presented "as is", reader beware!
Hiring employees is a big hassle for a sole proprietor who doesn't really need permanent manpower, but does need help with various specialized tasks. For the main part, the government would prefer that freelancing didn't exist because it makes the tax picture, especially collecting taxes from those freelancers, more complicated. So the IRS has a set of guidelines to try to keep businesses from hiring employees but treating them as independent contractors. The motivation is obvious. When I hire an independent contractor to do work for me, I pay them an hourly rate or a fixed price for the work, and write them a check. I don't withhold any taxes, I don't offer them any benefits, they do the job, get paid, and are gone. Most of the time, I don't even have to issue them a 1099 because they earn less than $600 from me during the tax year doing freelance jobs like proofreading, graphic design and editing. And that's one of the IRS's least favorite scenarios, because it means that these freelancers who may end up with well over $600 income in the tax year by working for multiple clients may not file a Schedule C since there's no paper trail (other than random checks written by unassociated parties) to let the IRS know that they have enough business income to be required to file.
Some professional help, like lawyers and accountants, aren't counted as independent contractors. Also, if you use independent contractors for doing certain repairs or in relation to your inventory (goods for sale), you may claim their expenses on those lines instead of line 11. As mentioned above, you have to file a Form 1099 MISC (miscellaneous) if you pay one of these independent contractors over $600 in the tax year you are filing. Otherwise, you can just add up the amounts paid. Some of the messiest situations occur when a business pays somebody as a freelancer, whether or not the amount requires a 1099 MISC, and that individual decides at tax time (or after being caught by the IRS for nonpayment of taxes) that they really thought they were an employee the whole time and thought that you were taking care of their taxes. What can you do if a contractor doesn't pay their taxes and tells the IRS they were really an employee? A document trail might help, but in the end, if the work they performed meets the definition of employee rather than contractor, it doesn't matter if you had it all in writing. If that accusation sticks, in addition to have to make up payments for income tax withholding, social security and medicare, there will be fines and penalty payments that you don't even want to dream about.
So, what defines who you can pay as an independent contractor, and who you must treat as an employee? The primary thing the IRS looks at is something they call "behavioral control", which really boils down to, is the person doing the work independently or at your beck-and-call. If you are telling an independent contractor when, where and how to do the job, the IRS may think you are treated that person like an employee. Further tests include, telling the person what tools to use, especially if those tools aren't industry standard. It would be OK for me to tell an editor I need back a marked up Word file because that's the way the industry works, but telling a cover designer what software to produce an image in would be suspicious.
It would be abnormal to tell your subcontractor who to hire or who they can subcontract to do the work, unless there are security issues involved. Why would you need that level of supervision over a true independent contractor, and why would they grant it? If you tell a freelancer where to purchase supplies and where to outsource the bits she isn't doing, you're treating the freelancer like an employee. The same may be true if you specify an individual to do a job that could be done by any competent professional, that's seen as if you were employing the person but paying them on 1099. Any overly detailed instructions, like, do A, B, then D, and afterwards come back and do C, makes it sound like you are treating the contractor as an employee. A related issue is training. Training is seen as something that a business provides to employees, not to freelancers or consultants, Since training costs time and money, for a sole proprietor to provide training to somebody and then to pay them on 1099 makes it look like the whole thing is just a tax dodge
Another major factor the IRS looks at is who controls the money, which they term "financial control." For example, the expenses an independent contractor incurs in the course of doing their work should not be paid by the business they are working for as if they were employees. The independent contractor is supposed to have taken account of these things in pricing the job or setting an hourly rate. If you are paying a mileage allowance, food, etc, for a contract worker, it may look fishy, though food may be normal if the work involves having to be somewhere away from the contractor's home base. It's also highly abnormal for an employee to invest in tools for work (imagine telling a new hire that they are responsible to buy Windows and Microsoft Office for their PC, or to bring in a lathe from home), so if the independent contractor can show that they have a significant investment in equipment or facilities, it's a good sign.
Speaking of money, employees are paid regular wages by the hour, week, or whatever the pay period is. Independent contractors and freelancers are often paid a flat fee for a job, with the business having no say over how many hours it will take. But it's also normal for independent contractors in many areas to charge an hourly rate for their time, and to invoice for that time on a regular schedule or at certain benchmarks as the work proceeds. And it's important to note that independent contractors can make a profit or a loss on a given piece of work, while an employee should never be in a situation where they can put in hours and lose money by working.
Another indication that a person is truly a freelancer is if they have other customers. If you are the sole customer of a freelancer, and year after year they do some fixed work for you without ever seeking work anywhere else, the IRS may want to treat that individual as an employee. True independent contractors are generally available to employment offers from the marketplace, and spend a reasonable amount of time seeking those opportunities. The IRS terms this as permanency of the relationship. If the business employs the freelancer with the expectation that the work will continue indefinitely rather than for a specific project or fixed period of time, that's evidence that the attempt was to get around the overhead of hiring an employee.
All of this is about defining the relationship between the sole proprietor and the freelancer or contractor, and you would think that a written contract would go a long way to proving the relationship is what you say. Unfortunately, it doesn't. The IRS sees written contract basically as a cover story, and it's only in a close case that they would even take a contract into account. Far more important is the issue of benefits. If you provide employee type benefits for an independent contractor, you are practically declaring that person an employee by default. Benefits include, vacations, insurance, sick pay, and any sort of retirement plan. A true self employed contractor is responsible to create his own benefit plan out of the profits from the work.
Finally, the IRS is skeptical that a business would outsource critical aspects of the day-to-day business of the company. If a freelancer or 1099 contractor is doing work that is absolutely critical to the regular business operations of the business, it's nearly certain that the business is controlling the activities of the person to an extent that isn't compatible with the role of a freelancer.
Until recently, the IRS had a more specific series of questions to check if a person was an employee or an independent contractor. The so-called twenty factor test may have looked simpler than the current guidelines, but in fact, it was difficult to really make sense of, many questions could be applied either way, and larger companies usually had an employment law attorney examine individual cases.
If you want the IRS to determine for you whether a worker is an employee or an independent contractor, you can file Form SS8. Even if you don't file it, you might want to fill it out for any substantial contracting (outsourcing) you do just to make sure you aren't missing a major point in your thinking.
Planning A New Business | Estimating Business Taxes | Schedule C Deductions | Car Expenses | Freelancer and Contractor Payments | Section 179 Depreciation and Form 4562 | Employee Benefits and Pension Costs | Professional Services, Business Taxes and Fees | Hotel and Travel Expenses | Deducting Food and Entertainment | Inventory and Cost of Goods Sold | Sole Proprietor Statistics | Home Office Deductions | Self Employment Tax | The Self Employed Sole Proprietor