Are you an employee or a contractor? Do you have an employee or contractor working for you? Why is it important to know the difference?
All of these are very important questions. Whether you are an employee, or own your own business, it is important to know the difference. There could be severe consequences for classifying incorrectly. Those consequences could range from back tax issues to penalties and interest to missing tax deductions to lawsuit settlements.
If someone is classified as an employee they must have taxes withheld for Federal and State (if applicable) and Social Security and Medicare. A contractor does not have to have taxes withheld. If you own a business and paid someone as a contractor that is later determined to be an employee, your company would be liable for the back taxes and penalties and interest on those back taxes. Additionally, if you are being paid as a contractor, you will be liable for paying all of your own federal, state, social security and Medicare taxes.
If you are an employee or are paying someone as an employee you must have workers comp coverage. If you are a contractor or paying someone as a contractor, you do not have to have this coverage. This is very important in the case of an injury.
How to Determine
Now that you understand the importance, how do you determine which one someone is?
The first step in determining whether you are an employee or a contractor or if you’re paying an employee or contractor is to review the rules of each. To be considered an employee, the services that are being performed would be controlled by the employer. That means the employer would control what would be done and how it is going to get done. The payer also would not control what would be done or how it would be completed, but they can direct the final result of the work to insure quality control.
Those are the basic fundamentals to the employee or contractor rule. But there are also other factors that help explain if the payer is controlling the services that will be performed. For example, an employee will be told when and where to work, what tools or equipment to use, what workers to hire or to assist with the work, where to purchase supplies and services, what work must be performed by specified individuals, and what order or sequence to follow. A contractor generally will not be given any of these instructions and will use their own equipment and judgment to complete the job. Another area has to deal with training. If the payer is directing the training to the payee, then this would also classify as an employer/employee relationship. Independent contractors ordinarily use their own training methods. Financial control is another area that can determine if you’re in an employee or contractor position. The biggest issue here is how the person is paid. An employee would generally be paid a regular wage amount for a period of time. A contractor is usually paid a flat fee or on a time and materials basis for the job.
Now that you have a good understanding of the difference between an employee and contractor and which one you or the person you are paying might be, let’s look at the reporting requirements for each.
An employee must fill out a W-4 and I-9 in order to work. The employer is required to collect this data and the employee is required to provide it. At the end of the year a W2 must be issued for the total amount of money paid. Additionally, an employer must file payroll reports with the federal government and the state agencies (if applicable) on a quarterly basis. Some agencies even require reports to be file more often than quarterly. Tax payments also must be made to the government agencies. How often those payments made are determined by how much and how often you pay your employees. The employee requirements are simply to fill out the W-4 and I-9. They also will file a tax return at the end of the year based off of the W2 information received.
A contractor has different requirements. A W-9 must be filled out by the contractor and given to the payee or business owner. At the end of the year a business must issue a 1099-misc to the contractor. The contractor must use this information to file a tax return on the appropriate business form. The business form is determined by the structure of the business (usually this is setup by an attorney).
The payer does not have to withhold any taxes or pay any insurance on the contractors behalf unless the contractor refuses to sign form W-9 or if you have received a letter from the IRS letting you know that you must withhold a mandatory 28% for that specific contractor. They also do not have to fill out any monthly, quarterly or annual reports. They will deduct 100% of the payments on their own tax return.
The payee or contractor must pay their own regular tax and SE tax (which includes Social Security and Medicare) on their tax return. They can deduct any and all expenses related to the contractor income.
In summary, there are tax benefits to being an employee or contractor depending on the situation. There are also tax benefits to paying an employee or contractor depending on the situation. For example, if you are paid as a contractor you can deduct all of your expenses related to that income and reduce yourself employment tax. If you pay someone as a contractor you will not have the time and expenses of additional taxes, insurance and reporting requirements. If you are paid as an employee you will not have the complex tax return to file at the end of the year and your taxes will be withheld by your employer. If you pay someone as an employee you will be able to deduct all costs associated with the employee.
As you can see, there can be pros and cons to each method. However, it really is not up to you to pick the best situation, but rather, be sure you qualify for each method. You must protect yourself by being aware of this information. Whether you own your own business or work for someone else we hope you find the value in this information.