As a small business owner, bringing in outside help is often the smartest way to get more done without hiring full-time employees. Freelancers can be a flexible, cost-effective solution for everything from graphic design and web development to bookkeeping and marketing.
But if you are not careful, the decision to hire a freelancer can turn into a major headache, especially when it comes to taxes and worker classification. Understanding the rules for hiring freelancers the right way is critical not just for getting quality work but for avoiding legal and financial trouble with the IRS.
Why Hiring Freelancers Appeals to Small Businesses
Before diving into the rules, it’s worth understanding why freelancers are such a popular option for small businesses:
- Flexibility: Hire when you need help without long-term commitments
- Specialized skills: Access experts in areas outside your team’s core strengths
- Cost savings: Avoid the overhead of full-time employment (benefits, payroll taxes, office space)
- Scalability: Ramp up or down based on project needs or seasonality
That flexibility is valuable, but it comes with responsibilities you can’t afford to ignore.
Pain Point: Misclassifying Freelancers as Employees
The biggest risk small business owners face when hiring freelancers is worker misclassification. If the IRS determines that someone you’ve called a “freelancer” is actually functioning as an employee, you could be on the hook for:
- Back payroll taxes
- Penalties and interest
- Unpaid benefits
- Legal claims (e.g., wrongful termination, unpaid overtime)
The line between contractor and employee is not always clear, but it’s your responsibility to get it right.
IRS Rules for Independent Contractors
The IRS uses a set of guidelines to determine whether a worker is truly an independent contractor or should be classified as an employee. These fall into three main categories:
- Behavioral control: Do you control how the work is done (schedule, tools used, training)?
- Financial control: Do you control how the worker is paid and whether they can earn profit or loss?
- Relationship type: Is the relationship ongoing, and are benefits provided? Is the work a key part of your regular business?
If you’re dictating how, when, and where a person works, they may be an employee, even if you call them a freelancer.
Pro tip: The more autonomy a worker has, the more likely they are to be classified as an independent contractor.
Step 1: Clearly Define the Role and Project
Start by being specific about what the freelancer will do. Instead of saying “help with marketing,” say “create 10 email templates and write three blog posts for our Q3 campaign.”
Define:
- Scope of work
- Deliverables
- Timeline
- Budget or payment structure
- Required tools or platforms
This clarity sets expectations for both sides and reinforces the project-based nature of the relationship.
Step 2: Use a Freelancer Agreement
A written agreement protects you and your freelancer. It doesn’t have to be overly complex, but it should cover:
- Scope of work
- Payment terms (flat fee, hourly rate, milestones)
- Timeline or deadlines
- Ownership of work or intellectual property
- Confidentiality clauses
- Termination clause
- IRS classification statement (acknowledging they are an independent contractor)
Make sure both parties sign the agreement before any work begins.
Step 3: Collect the Proper Tax Forms
To stay IRS compliant, you must collect the right tax documentation from freelancers.
- Form W-9: This form provides the freelancer’s name, address, and Taxpayer Identification Number (TIN). You must request it before issuing any payments.
- Form 1099-NEC: If you pay a freelancer $600 or more in a calendar year, you must issue this form by January 31 of the following year. It reports how much you paid them.
Note: You only need to issue a 1099 if the freelancer is an individual or unincorporated entity (e.g., sole proprietor or partnership). You typically don’t need to issue a 1099 to a C-Corp or S-Corp.
Step 4: Avoid Giving Freelancers Employee-Like Perks
To maintain a clear boundary, avoid treating freelancers like full-time employees.
Do not:
- Set their working hours or location
- Provide company equipment (unless necessary for project-specific work)
- Include them in staff meetings or benefits programs
- Give them performance reviews or promotions
The more you blur the line, the more likely the IRS (or your state labor agency) will see them as an employee.
Step 5: Track Payments and File Taxes
Keep good records of what you pay each freelancer. You can use bookkeeping software like:
- QuickBooks
- Wave
- Xero
- FreshBooks
Make sure your accounting software tracks contractor payments and generates 1099 forms at year-end.
Also, note that payments made through third-party processors like PayPal or Venmo Business may be reported separately on Form 1099-K, which reduces your reporting responsibility. However, you should still keep records for your own compliance.
Step 6: Understand State-Level Requirements
In addition to federal rules, some states (like California) have stricter definitions of who qualifies as an independent contractor. The ABC test is commonly used and requires:
A. The worker is free from control and direction in performing the work
B. The work performed is outside the usual course of the company’s business
C. The worker is engaged in an independently established trade or profession
If your freelancer does work similar to what your employees do, or works under your direct control, they might fail the test.
Be sure to review your state’s specific labor laws or consult a local employment attorney.
Red Flags That Could Trigger IRS or State Scrutiny
- You work with the same freelancer for months or years, without changing the scope
- You pay them regularly like a paycheck instead of by project or milestone
- You require them to work certain hours or use company email
- You treat them like part of your team publicly (e.g., listing them on the website as staff)
These are all signs the relationship might resemble employment more than freelance work.
Step 7: Build a Freelance-Friendly Culture
When done right, hiring freelancers can be a huge asset to your business. Here are a few ways to keep things running smoothly:
- Communicate clearly and consistently
- Pay on time
- Respect their independence
- Provide detailed briefs and project goals
- Give constructive feedback when appropriate
- Refer or rehire top freelancers for future projects
Strong freelancer relationships lead to better work and lower turnover.
Final Thoughts: Stay Smart, Stay Compliant
Hiring freelancers the right way is about more than getting the work done. It’s about protecting your business, staying within the law, and building a reputation as a trustworthy client.
By following the rules, keeping clear boundaries, and maintaining strong documentation, you can work with freelancers confidently and avoid IRS trouble.
A little preparation now can save you a lot of hassle later, and help you grow your business the smart way.