Employee vs Independent Contractor: Which One Do You Have?
Are you able to easily differentiate between independent contractors and employees? Whether you are an established business or a growing startup, it’s important to properly classify workers to avoid Uncle Sam knocking on your door.
In this article, we will outline how to differentiate between an employee and an independent contractor using the IRS’s Common Laws, the advantages and disadvantages of each worker class, and how year-end reporting differs.
Differentiating Between an IndependentContractor and an Employee
Accurately differentiating between an independent contractor and an employee relies on understanding the degree of control and independence. The IRS’s CommonLaw Rules break down these factors into three different categories:
1. Behavioral– Who controls the tasks the worker completes? Employees will generally be under your direct supervision, while independent contractors will control their own work methods and tasks.
2. Financial– Do you set the pay rate? If you set the rate of pay, you most likely have an employee. Independent contractors determine their own pricing structure. In addition, benefits, such as health insurance and retirement matches, indicate an employee. An independent contractor will not be able to partake in benefit programs.
3. Type of Relationship – Is the worker expected to work for an indefinite period or is it a one-time contract? Employees will generally have a contract without an end date, while an independent contractor is commonly hired for a specific project or job.
Determining which class of worker you have can be confusing, which is why it’s best to reach out to an accountant for help. Misclassifying your employees can lead to significant penalties, with back taxes and interest being owed to the IRS and other regulatory agencies.
The Advantages and Disadvantages of an Employee
Deciding which type of worker to hire can be difficult, making it important to understand the advantages and disadvantages of each. First, employees are advantageous from a control standpoint. As the employer, you are able to dictate what the worker does on a daily basis, assigning tasks based on your business’s needs.
In addition, employees have more loyalty to your business. This is because they are relying on regular wages and might not have another income stream. When you can depend on reliable help, you can scale your business with added ease.
The top disadvantage of an employee is payroll taxes. Employers are required to remit payroll taxes, including social security, medicare, federal unemployment, and state unemployment taxes. These amounts can add up, costing you more to retain the worker. These taxes also subject your business to regular filings.
Federal and state taxes are required to be withheld and remitted from your employee’s checks on a predetermined schedule, which is usually monthly or semi-monthly. This can add to your growing to-do list.
The Advantages and Disadvantages of an Independent Contractor
Independent contractors also retain a specific set of advantages and disadvantages. One of the major benefits of retaining independent contractors is no employer payroll tax liabilities. Independent contractors are in charge of remitting their own taxes, saving your business on payroll taxes.
Another advantage of independent contractors is that you are not obligated to offer them company benefits, like retirement matches, stock options, and insurance. This can reduce your costs and contribute to your profitability.
However, independent contractors aren’t required to be loyal to your business. Odds are that the independent contractor is working with other companies. If a conflict comes up, they may choose to work with the other business over yours, leaving you in a tough position.
Additionally, you have no control over the prices charged by independent contractors. Since they are running a separate business, you must either pay the price they are requesting or search for other contractors.
Understanding Year-End Obligations
The year-end reporting is different for employees and independent contractors. Employees will be issued a W-2, which outlines the wages earned, taxes withheld, and benefits offered. Issuing W-2s might come with more reporting requirements. For example, if you offer fringe benefits, like personal use of a company car, you will need to add back these amounts of towages. This makes the process more complex.
On the other hand, independent contractors are issued 1099-NEC. This form outlines the gross amount paid to the contractor. You aren’t required to issue a 1099-NEC to every contractor. Instead, only contractors that earn over $600 and are not incorporated should receive this form. Independent contractors can elect to have federal and state taxes withheld from their earnings, but this is not very common.
Choosing Your Workers
So, what type of workers should you choose? If you are looking for reliable workers, you should hire an employee. This is because employees retain more loyalty towards your company. Moreover, if you want control over the operations of the employee and expect to be their sole employer, you are looking for an employee.
Looking for an employee over an independent contractor can also make the hiring process simpler. Many individuals look for stability and benefits in their work. Offering a fair wage and benefits can help your business attract qualified talent.
It’s more common to hire employees compared to independent contractors. This is because it’s riskier to classify a worker as an independent contractor if you are their sole source of income. The IRS will not hesitate to audit your business and assess back taxes.
Independent contractors are used for one-time projects. If you need assistance on a specific deal or project, you will most likely hire an independent contractor. The employment is short-term in nature and there is no formal employment agreement in place.
Do you know which type of worker you have? Most businesses have a mix of employees and independent contractors. This makes it important to ensure you have the proper employment classification in your accounting system to issue accurate year-end forms.
For help deciphering what class of worker you have, reach out to one of our team members at Bookkeepmetoday. We can help you navigate the complexities of being an employer.