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IRS needs to acknowledge the freelance economy

The way we work in the United States has gone through a fundamental shift — a trend that by all estimations should continue. A shift away from manufacturing has led to the rise of service providers. Technology has enabled a "sharing economy." Plus, workers who have learned the hard way over the last decade that no job is secure have turned to self-employment as a means to secure their own destiny.

IRS Internal Revenue Service
Andrew Harrer | Bloomberg | Getty Images

The numbers are staggering. Recent research, conducted by Edelman Berland and commissioned by the Freelancers Union and Elance-oDesk, estimates that 34 percent of the American workforce, approximately 53 million Americans, are doing some type of freelance work. And this likely doesn't fully count all independent contractors, including the approximately 22 million one-person small businesses around the country.

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However, while the work landscape has and will continue to evolve, the government-affiliated groups like that IRS who define who is considered an employee, have not. That means that there is a disconnect between people who consider themselves independent and the businesses that engage their services on one hand, and the tax and paperwork implications of the IRS definition of what is an independent worker on the other hand.

"1099" workers are those considered independent by the IRS. "W-2" employees are those they consider employees. However, for many freelancers, small businesses and their temporary employers, the definitions often don't match. Moreover, this distinction can end up being very costly, both in penalties from miscategorizing contractors and freelancers, as well as from the opportunity cost of not bringing on freelancers or service providers that may subject a business to categorize them as employees and the extra work associated with doing so.

Per the IRS, "Generally, you must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to an employee. You do not generally have to withhold or pay any taxes on payments to independent contractors."

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This may seem like a small distinction, but to small-business owners who are already consumed with burdensome administrative tasks, not to mention a cost structure that may not be yet scalable, it is a significant one. It creates more time and expense related to paperwork and compliance. Plus, having freelancers and contractors categorized as employees can impact the 401(k) or other retirement plans of a businesses.

The criteria for who is considered a freelancer/contractor by the IRS, and who is not, is fairly stringent. The IRS says that if you perform work that would be done in the normal course of business by an employee (including, among other things, not setting your own hours or methodology for completing the work), you are considered an employee, not an independent contractor, for tax purposes. This stands even if you own your own firm, have additional clients and/or just plain want to be one.

This can have tremendous financial implications for businesses. Business owners can be hit, as was this recently profiled small business, with thousands of dollars or more in back taxes if the IRS believes that your freelancers or contractors are should be categorized as employees. Others small business owners are purely reluctant to hire because they don't want to accidentally run afoul of any regulations and face issues down the road.

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It is very clear that this outdated definition creates a barrier to hiring, which is neither good for the growth of small business or for the growth in the workforce, and is precisely why it should be changed immediately.

Imagine that a small business only needs a person for projects, for shortened hours or even for part of the year. Having an updated 1099 definition would allow a freelancer to be able to be employed by multiple businesses without creating redundancy in administrative work and other paperwork.

If both parties are in agreement that an independent contractor arrangement makes sense, why would the government stop that? If the contractor or freelancer is paid more than $600 a year by a business and have a non-corporate entity (LLC, Sole Proprietorships), their income is reported through a form 1099-MISC to the IRS each year. Income and other taxes are still getting paid. While businesses pay and collect Social Security and Medicare taxes (aka FICA taxes) for each employee, an independent contractor is subject to self-employment taxes, which cover both Social Security and Medicare contributions in an amount roughly equivalent to the FICA tax. So, why should the government and the IRS care which entity is responsible for those taxes? Shouldn't that be up to the parties in the work arrangement?

Allowing more individuals to work as freelancers and be classified by independent contractors as they are hired by other businesses should, in fact, increase tax revenues by making it easier to create jobs.

As we look at ways to put people back to work and foster a pro-growth environment for small business, a simple definitional change in the tax code would go a long way towards helping our economy. The freelance economy is not going away and it's time for the IRS to catch up.

Commentary by Carol Roth, a "recovering" investment banker (corporate finance), entrepreneur/small-business owner, investor and author of "The Entrepreneur Equation." Follow her on Twitter @CarolJSRoth.