April 20 2016
Congratulations! Your business is growing and you need to add a new team member to your roster. Will you hire an employee or an independent contractor? Be certain you know the differences between the two to save yourself a costly misstep.
As a business owner, this is one of the most important distinctions you'll need to make, mainly because it decides which taxes you'll need to pay and when. Classifying a worker incorrectly can lead to huge penalties from the IRS, as it has for Uber, Google, and FedEx.
The IRS has four classifications for workers:
- Independent contractor
- Statutory employee
- Statutory non-employee
For most small to medium business owners, the two classifications you'll use the most are Employee and Independent Contractor.
Classifying a worker
There are three factors to consider when classifying a worker. They are: behavioral control, financial control, and the type of relationship.
Do you have control over the worker's time? Do you control where, how, and when they work? Do you provide the training and direct the work?
If you answer no to these questions, the worker is an independent contractor. Independent contractors will set their own hours and decide how the work is completed.
If you train the worker, set the hours they will work, and control where and how they will do the work, the worker is an employee.
Another thing to consider here: If you provide the tools the worker will need to complete the job, that worker is an employee. If the worker uses their own tools to complete the job, the worker is most likely an independent contractor.
If the worker is paid a salary or an hourly wage, they are an employee. If you pay a flat fee for a specific project or job, the worker is classified as an independent contractor.
Also, if the worker is allowed to work with other businesses at the same time as yours, or if they incur a profit or loss from the work they do for you, they are generally considered an independent contractor.
Type of Relationship
This factor can be a bit tricky to determine as it allows for best judgement. It pertains to the relationship between the worker and the business owner. If the work that is being done directly relates to the business's work, then the worker is likely an employee. On the other hand, if the work is a service that doesn't directly influence the company, they could be deemed an independent contractor.
Here's an example:
If you run a restaurant and you hire a web designer to design your website, you are hiring an independent contractor. If you hire a server for the restaurant, you are hiring an employee.
The tax implications
For most business owners, there's a benefit to hiring an independent contractor for certain types of work. You'll save on labor costs (benefits, etc.), have reduced liability, and more flexibility when it comes to hiring and firing practices. Because of this, it can be tempting to classify a worker as an independent contractor when the worker is truly an employee.
So what happens if you hire an independent contractor who should have been classified as an employee? Whether you meant to do it or not, it will cost you. The IRS can come after you and you may be required to:
- reimburse them for wages you should have paid them, including overtime and minimum wage
- pay back taxes and penalties for federal and state income taxes, Social Security, Medicare, and unemployment
- pay any worker's compensation benefits
- provide employee benefits, including health insurance, retirement, etc.
You'll need to file different tax forms depending on if you hire an employee or an independent contractor. If the worker you hire is an employee, you'll need to file a W-2, in addition to withholding and paying certain taxes and benefits. If you choose to hire an independent contractor, you'll need to have them fill out a W-9 and file a 1099-MISC, if you pay them more than $600 or more during a tax year.
By understanding the differences between hiring an employee and an independent contractor, you'll feel confident you're making the best choice for your business. Your accountant can also help you to make the best choice for your business when it comes time to grow.
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