Making the Most of Freelance Talent

The IRS is Watching

Government agencies are ramping up their oversight of employers who use freelance workers

It is one of the ironies of outsourcing: You want to find freelancers who function as smoothly and effectively as staffers. But if you treat freelancers too much like employees, you are liable to be penalized by the IRS and other government agencies for “worker misclassification.”

And employers have never been more vulnerable. In February, the IRS began a three-year initiative to crack down on worker misclassification. Six thousand businesses have already been targeted for audit.

At the same time, President Obama's budget proposal for 2011 includes $25 million in new Department of Labor spending, including 100 new employees to ramp up enforcement of employee misclassification.

Worker misclassification occurs when a government entity decides that a contractor, freelancer, temp, or 1099 worker is really an employee and entitled to the benefits and protections dictated by employment law. On the financial side, they want the income from the employer's share of taxes (Social Security, Medicare, unemployment, workers' compensation).

What can misclassification cost you? According to James Coleman, partner with Constangy, Brooks & Smith, a national labor and employment law firm, the IRS may go after all sums that should have been withheld retroactively, including the employer's share of Social Security, Medicare, unemployment insurance, interest and penalties.

Misclassification actions brought by the Department of Labor can result in retroactive minimum wage, overtime, liquidated damages equal to the back wages and an award of costs and attorneys' fees.

Obama's budget proposal also calls for better collaboration between state and federal efforts to identify misclassified workers. So, once a business has been tagged, it will likely be subject to additional investigations by other agencies.

Certain industries with a history of misclassification are being targeted: trucking, construction, restaurants, grocery stores, janitorial, business services, child care, poultry and meat processing, landscaping and home healthcare. But any company that issues a large number of 1099s or has a relatively large percentage of independent contractors versus zero employees has higher potential for an audit.

Also, many audits are triggered by a claim for workers' compensation or unemployment benefits from a contractor. Others are brought about when one or more contingent workers decides to sue. In addition, the IRS Whistleblower Program allows a disgruntled worker or competitor to pocket 15 percent to 30 percent of the amount collected if the company is found to be in violation.

Although some federal and state agencies mirror the IRS rules, many do not, so it's crucial that you seek the advice of an attorney if you have any doubt about worker classification.

The IRS website,, explains the criteria for determining whether a worker is an employee or independent contractor. They fall into three categories:

  • Behavioral: No-nos include telling contractors where, when or how and in what sequence they're to perform their job; providing training; requiring them to use or purchase certain tools or supplies; evaluating how work is performed rather than the result.
  • Financial: Contractors should have an investment in their own businesses, have an opportunity for profit or loss, not be reimbursed for all expenses, make their services available to the public, and, in most cases, be paid by the project rather than hourly.

  • Type of relationship: There should be a contract and, preferably, work should be off-site. Contractors should not receive benefits, be guaranteed a continuing relationship, do work that's similar to work done by employees (now or in the past) or perform work that's a key business function. --K.L.
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Kate Lister is a former banker, small-business investor and veteran entrepreneur. Her books and websites include Finding Money: The Small Business Guide to Financing and Undress For Success: The Naked Truth About Making Money at Home.

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This article was originally published in the September 2010 print edition of Entrepreneur with the headline: Freelance Nation.

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