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Employee or Independent Contractor? How the Decision May Significantly Impact Your Freelance Finances

CPA for Freelancers Advice for Self-Employed

A recent ruling by the California Supreme Court made it more difficult for employers to classify their workers as independent contractors in response to criticism by some that companies are not properly classifying independent contractors as employees. This law seeks to tighten the rules regarding worker classification and reignites the debate about when a freelancer should really be classified as an employee—and what the financial ramifications of such decisions may be. Here’s what freelancers should know as other states consider similar actions:

Who could be reclassified under the new law? The new California bill essentially seeks to tighten the worker classification by instructing businesses to use the “ABC test” to determine if a worker should be classified as an employee. To hire an independent contractor, businesses must prove that the worker is (a) is free from the company’s control, (b) is doing work that isn’t part the company’s core business, and (c) has an independent business in the industry congruent with the services it is providing. If an independent contractor doesn’t meet all three of these conditions, they would, by law, have to be classified as an employee and receive benefits accordingly. In addition, the law would require companies to pay matching social security, Medicare and unemployment coverage to these individuals.

Employers favor freelance working arrangements. Currently, independent contractor working arrangements are not subject to government rules on minimum wage, overtime and rest breaks. In addition, employers do not have to furnish independent contractors with healthcare or other benefits typically given to a traditional employee. They also do not have to pay payroll taxes since independent contractors pay their own Medicare and social security taxes. This makes the economics of hiring of freelance workers as independent contractors attractive to many businesses in comparison to regular employees.

Why state and federal governments and employee union organizations are interested in worker classification. Both the government and labor unions are becoming more proactive in looking at how these working arrangements should be treated and whether some independent contractors should be reclassified as regular employees. They claim that doing so will make working arrangements more fair and safer for independent contractors. The IRS is also looking at worker classification to ensure that appropriate payroll taxes are being paid by employers—as you can imagine this represents a significant potential revenue bump.

How does being classified as a worker impact freelancers? While being classified as a regular employee may appear to be more beneficial to freelancers at first, it may actually be financially detrimental from a tax perspective—to the tune of 30 percent more in income taxes and other expenses every year. This is because being employed would eliminate tax deductions for self-employed individuals such as those for health insurance and business expenses.

In addition, many independent contractors are hired by small businesses on a part-time basis making them ineligible for benefits and would have to pay for their own. There is also the issue of whether an employer would pay for liability and errors and omissions insurance or if freelancers would have to pay out of their own pockets. As you can see, the financial impact on freelancers who are reclassified as workers may be significant.

Keep an eye on how these court rulings play out. There’s no doubt about it…the gig economy is growing, which means it is gaining more and more attention from both the government (for payroll tax purposes) and labor unions (to ensure fair working standards). The unanimous California Supreme Court ruling could have serious financial implications for freelancers and self-employed people in every employment sector. Stay tuned so you know what impact it may have on your freelance finances.

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Jonathan Medows, CPA

Jonathan Medows is a certified public accountant licensed in New York, New Jersey, Maryland, and Pennsylvania. He is also a recognized expert in taxation for freelancers and the self-employed—often tapped for his expert knowledge and perspective on self-employment taxation by national and regional publications such as The New York Post, BusinessWeek, Forbes taxation blog, WebCPA, CPA Practice Advisor, and others. You can read some of Jonathan’s press coverage here.

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