When paying freelancers, you are not required to withhold:
- Federal taxes
- State income taxes
- Social Security
- Medicare
The reason you do not have to worry about withholding is that freelancers are considered to be self-employed, and must calculate and pay their own taxes. 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’ taxable income.
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 employee’s paychecks.
In addition to withholding taxes from your employees, you will be responsible for paying your portion of Social Security and Medicare taxes as an employer, which equates to 7.65% per employee.
As an employer, it is likely 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.
Considerations Between Freelancer and Employee
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.
Employees add an administrative burden in managing payroll and tax withholding, which can be more complex and time-consuming than working with freelancers.
Hiring employees may provide greater control over and consistency among your workforce.
Properly Classifying 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’ relationship with the IRS. While independent contractors can serve as a way to reduce your business expenses, hiring them is not 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.
Employee Classification
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
Penalties you face misclassifying workers will depend on whether the IRS and Department of Labor believe you made the error on purpose or by accident.
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 did not withhold from employees
- 0.5% of your unpaid tax liability up to 25% for each month
The government does not take 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.
It is important to understand the difference between a W-2 employee and 1099 freelancer, not only to avoid penalties but also because you can benefit from financial perks for your business.