Contractor vs. Employee? – How to Gauge Your Tax Responsibilities
4 min read
December 31, 2019 • Block Advisors
Are you looking to grow your business in the coming year? With growth comes the question, “What is the tax treatment of a contractor vs. employee?”
Employees and contractors have characteristics that set them apart from each other in the eyes of the IRS. Read on to gain insight into the difference between employees and contractors and the tax implications of each.
The Difference Between Employees and Contractors
Worker classification determines if an employer must:
- Withhold income taxes and FICA (Social Security and Medicare) taxes from an employee’s compensation
- Pay the employer’s share of FICA taxes as well as unemployment tax on employee wages.
Here’s a quick refresher on the definitions. According to the IRS:
There are three basic areas of determining if an individual is an employee or a contractor. They are:
- Behavioral Control – Whether the business has a right to direct and control how the work is completed.
- Financial Control – Whether the business pays business expenses and provides tools.
- Relationship of the Parties – Whether the business offers benefits, such as insurance, vacation, or sick pay, as well as the permanent of the relationship and the nature of written contracts describing the relationship the parties intended to create.
If you hire an employee, you must withhold and pay in the employee’s federal, state, and local taxes and the employee’s share of FICA taxes.
In addition, you must cover:
- Employer FICA taxes: 7.65% of the employee’s wages.
- Federal Unemployment Tax Act (FUTA) taxes: FUTA is generally 6% of each employee’s first $7,000 in wages.
- State unemployment insurance (SUI), if required by your state.
Other costs associated with employees are:
- Worker’s compensation
- Overtime pay
Employee tax forms: They receive a W-2 for tax reporting.
You are responsible for completing Form W-2, Wage and Tax Statement, for each employee. Form W-2 must be submitted to the Social Security Administration and copies must be furnished to the employees by January 31 after the close of the year.
If you control or direct only the result of the work and not how the work is done, you have likely hired an independent contractor.
Contractors are usually classified as self-employed individuals, which means they are responsible for paying their own taxes.
An independent contractor’s earnings are subject to income and self-employment tax. Because businesses don’t withhold taxes on payments to independent contractors, contractors must estimate their tax liability and pay estimated taxes in four equal installments throughout the year.
Contractor tax forms: They receive a 1099 Form for tax reporting.
As a small business owner, you are responsible for completing Form 1099-MISC with box 7 (nonemployee compensation) checked. Previously, the form, alongside Form 1096, was to be submitted to the IRS. Starting in tax year 2020, new Form 1099-NEC should be used for this purpose.
Should You Hire a Contractor or Employee? [Checklist]
Are the following true? If so, you have likely hired an employee. (And conversely, are the following false? If so, you have likely hired an independent contractor.)
- Does the worker have to follow instructions for when, where, and how to work?
- Will the worker perform tasks on a schedule you set?
- Will the worker be required to come into your physical office?
- Will the worker need to use your business’ equipment or supplies?
- Will the worker work for an indefinite period of time for your business?
- Will the worker be allowed to work anywhere else outside your own business?
- Will the worker perform daily activities central to your business’ operations?
- Will training be required?
- Will you have interest in seeing how the work is performed, versus just seeing the final product?
- Will the worker be paid a fixed amount on a fixed schedule?
- Could the worker be fired or quit at any time without cause?
Why Care About the Distinction Between Employees and Contractors?
Employees and contractors are not interchangeable, and the IRS and state courts agree. Each type has its own classification from a legal standpoint. If you fail to classify workers correctly, you could be subject to penalties, back taxes, and other costs.
For help with small business taxes, consult a tax professional at Block Advisors.