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The IRS and the Freelance Dilemma

Joe Strike takes a look at the tax implications for freelancing on both employers and contractors and how companies like MBO Partners can help.

He's smiling now, but wait until tax time.

The IRS and the imaginary sequel to Mel Brooks’ Spaceballs have one thing in common: they’re both in search of more money.

For Brooks, it was just a gag; for the IRS, it’s a mission to plug what the agency sees as a $14 billion annual gap between their estimates of taxes due and what was actually collected – and for a while now they’ve been targeting the nebulous world of the 1099-paid freelancer or independent contractor. That person may be doing the same work as a fulltime employee, but both the freelancer and the company avoid paying upfront income or social security taxes. The IRS had been scrutinizing companies like Microsoft and Federal Express, outfits that made use of so many freelancers on a long-term, open-ended basis it gave birth to the word ‘permalancer.’

In recent months however, the IRS has set its sights on the animation and visual effects industries. (California and New York – states hosting huge amounts of production work – have also become more aggressive in their tax-collecting efforts.) It’s a world where animators and effects artists are nomads, travelling from company to company, coming on board to work on a commercial or a movie before moving onto a new project at the next shop that needs their services.

It might sound exactly like a freelancer’s lifestyle, but the IRS says that’s no longer the case. “The government is putting the burden on the employers – ‘if we believe they should be employees we will bill you’ for their taxes and Social Security payments,” says Gene Zaino, President and CEO of MBO Partners. “The common law test of whether someone is an employee or freelancer basically consists of three elements: behavioral, financial, and the relationship of the parties.

“The behavioral component is if you’re providing the worker with instruction they’re an employee. Financially, if a contractor is paid by the hour or day, they’re an employee, but if they’re paid on deliverables they qualify as a contractor. The toughest aspect is the relationship of the parties: if the freelancer’s work is similar to what employees do, or if their work is critical to the company, as far as the IRS is concerned, they’re an employee.”

The IRS has been turning up the heat – and companies are sweating the possibility of being hit with heavy fines and tax levies (this past September the IRS handed FedEx a whopping $14 million bill); they’re looking for ways to keep the government happy and still be able to use talent on a per-project basis without people constantly jumping on and off their payroll.

Payroll companies that bill a freelancer’s client, then pay the freelancer as if they worked for the payroll company have been around for a while, but MBO has come up with a service for the animation/effects industries – one that not only protects the company from the glare of the IRS, but simplifies the entire financial back-end of doing business with (and as) a freelancer.

“The freelancers are basically employing themselves through us,” explains Gene Zaino, the company’s President and CEO. “Essentially, the artist becomes a division of MBO.” Zaino describes an online-based process where the artist is free to negotiate their rate with the client. After a contract is signed the artist submits a work order to the client for services rendered on an hourly, daily or per-project basis. Once the work order is approved it becomes the basis for the invoice MBO sends to the client for the freelancer’s services. “The bill goes out under MBO’s name and tax ID,” Zaino adds, “but the freelancer can have their name and even their logo on the invoice.”

Payments to MBO are made via electronic transfer and the artist can monitor the entire process from their computer. The artist’s expenses (usually from receipts submitted via scanner or iPhone photo) are deducted from their pre-tax billings and the artist is paid the balance either by check or more likely, an electronic transfer directly into their bank account from which withholding taxes and Social Security payments have already been taken out.

It’s a win-win process: the employer is sheltered from the wrath of the IRS and the artist has the equivalent of a back-office doing the bookkeeping, going after slow-paying clients and performing other tasks creative people often let slide; opt-in benefits like low-cost health insurance and an “aggressive” retirement investment program sweeten the deal.

Someone has to pay for all of this, and that payment takes the form of MBO’s 5% cut of the artist’s paycheck. (Once past the $125,000 mark, MBO’s fee drops to 1.5%.) It’s an expense usually shared by the artist and the client, who is also benefiting from the legal shelter and tax payments MBO provides.

Companies like MBO Partners give freelancers and employers protection from the IRS.

“Right now some 200 animation and effects people in 21 or 22 companies are using our services,” say Zaino, including Psyop and Gretel in New York as well as Motion Theory in Venice. Even though MBO tracks their artist’s finances, they don’t (as of yet) do their tax returns, but “we do plan to build a network of accountants to partner with. We’ll be able to upload data directly to their computers.

“We’re focusing on infrastructure – there are a lot of things we’re actively considering like building a connection center where our people can access services like car rentals, accountants and even each other. I’d say it’s about a year out at this point.”

Psyop’s Chief Financial Officer Tom Boyle traces the consultant/employee schism to the dotcom days of the late 1990s when Microsoft “treated consultants the same as employees. The IRS told the company ‘you should’ve been withholding payroll taxes,’ and once the consultants realized they fit the definition of an employee while the guy sitting next to them really was an employee with stock options, they wanted some of that wealth too."

Boyle cites cases where a person worked one day on a project “and the Department of Labor came back and said for that one day they were your employee, you should put them on your payroll for that one day,” the sort of episode that prompts companies like his to use MBO. He estimates that 90% of the freelancers who come through Psyop are paid through MBO. “Only about 10% of them would pass the test as a true consultant,” he says, illustrating the difference between a contractor and an employee. “It’s more than only coming in a small number of days; we don’t control or supervise them, they don’t use our equipment, they’re not working on our premises.

“Think of a painter who comes to your house, gives you a quote and asks you what color you want. Then he comes back, sets his own schedule, hires other people to work for him, brings his own equipment. At the end of the day you pay him. That’s what they call a true independent contractor. Not someone who comes to your office, uses your equipment, comes to meetings with you, and does the same work as your regular employees.

“We chose MBO as our preferred vendor. We won’t take any freelancers unless they come in through MBO or a similar company. We met with a few other companies,” Boyle admits, “but we thought Gene understood all the issues a company faces, and they make us compliant with the regulatory environment, which is critical.  They’re a nice solution for our industry. We’re able to engage freelancers on our projects in accordance with the IRS and Department of Labor employment practices. I don’t have to worry about the IRS knocking on my door and telling me ‘this man should be an employee.’”

Bora Pena is a 27-year old artist and compositor working the New York freelance circuit. “I prefer freelancing. I have my rate, I have my freedom. I’m not ready to be tied down; I’m in a creative industry where I’m doing motion graphics one day, but next week I might want to become a cartoonist. Freelancing is the only way you can say ‘I’m dying, I’m going to take a three-month break.’ If you’re a full-timer, you’re stuck.”

Pena remembers the good old days not all that long ago of freelancing: “It was a lot easier when the industry was flourishing to invoice a client, get your check the next week and put it in the bank – it was almost like going to an ATM, it was intense. There was so much money being thrown around – you could permalance for months and months and months. You’re accumulating tons of great checks every month, and you’re in New York.

It’s a lifestyle; you’re working constantly. It’s a creative industry and unfortunately some of us are uncontrollable when it comes to spending, because you don’t realize how valuable it is to save some of it until the end of the year. I made my mistakes when I started out; when tax time came around I owed $20,000 and I wound up on an IRS payment plan.”

MBO Partners offers online resources so freelancers can manage their money.

Pena attended an MBO presentation while working at Psyop this past summer. “MBO and another company came to Psyop. All the freelancers I work with liked what MBO had to say; they were all older than me and they chose MBO.” He credits the company with helping him simplify and discipline his financial life. “I invoice MBO, I list the number of days I work through them. Everything is on the record – I can log onto my [page on the MBO] website and see everything I’ve done.”

In his bad old freelance days, Pena would accumulate a mountain of receipts to dig through every year at tax time, but after signing with MBO “you get into the groove you submit your expenses every week you know how many are getting approved based on tax-related reasons. At the end of the week MBO invoices the company and you see everything right away – when the invoice was sent, when the company approved it. It’s easier to keep track when you don’t have to keep track of the numbers – all you have to do is log into the website and see what the latest update is.

“The employer pays MBO, MBO takes taxes out and pays you. The money you’re getting you can actually spend.” Pena tempers his enthusiasm for MBO, noting there are “pros and cons” to the relationship. “The con is you’re going through a middleman – you have to learn to trust these people – what they’re taking out why they’re doing it.” He adds that the company’s presence in New York only dates back to this past summer, and hasn’t taken him past tax season yet. “We’ll see how it plays out. We’re all naturally impatient because we live in New York.”

Joe Strike has written about animation for the New York Daily News, Newsday, and New York Press. He is currently teaching Mass Communications at New York’s St. John’s University and hosting “Interview With An Animator” at Pratt Institute. He has scripted for the Nickelodeon series Wow! Wow! Wubbzy!, adapted anime scripts into English and worked on the children’s TV series The Great Space Coaster and Pee-Wee’s Playhouse. After helping launch the cable service formerly known as the Sci-Fi Channel, Joe wrote and produced programming featuring celebrities like Stan Lee, animator Ralph Bakshi and the cast of Mystery Science Theatre 3000.

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