Hiring workers to help you achieve your business dream can lift a huge weight off your shoulders. But if you don’t know how to correctly classify them, you might face even bigger problems. Understand the difference between independent contractor vs. employee, find out how to report wages, and learn how to decide worker status to avoid legal issues.
Independent Contractor vs. Employee
Knowing whether a worker is an independent contractor or employee can be difficult. Before you can decide between the two, learn what sets them apart and how the difference impact taxes and wage reporting.
An independent contractor is a worker who provides services to businesses but works for themselves. Examples of independent contractors can include doctors, construction workers, and accountants.
Independent contractors are not your employees. You might hire an independent contractor if you need a specific task done at your business. Key characteristics separate an independent contractor from an employee, like their ability to control how they do the project. And, independent contractors can perform work for multiple businesses at the same time.
Wage Reporting for Independent Contractors
When you pay independent contractors, you do not withhold taxes from their wages. Instead, the independent contractor is responsible for paying self-employment tax and other taxes. Do not do anything with taxes for independent contractors.
Although you don’t withhold taxes from an independent contractor’s income, you do need to report wages of at least $600.
You must report wages on Form 1099-MISC, Miscellaneous Income, by January 31 and send a copy to the IRS, state tax department (if applicable), and copies to the independent contractor. And, keep a copy in your records.
Fill out Form 1099-MISC for each independent contractor who did work for you in the year. When you send Forms 1099-MISC to the IRS, you also need to send Form 1096, Annual Summary and Transmittal of U.S. Information Returns.
Employees are not temporary workers. You can control an employee’s work, and their work is an important part of your business. They are included on your payroll. Examples of employees can include managers, receptionists, and salespeople.
Wage reporting for Employees
When you pay employees, you need to withhold income and FICA (Social Security and Medicare) taxes from their paychecks. And, you need to make a matching employer contribution for FICA tax.
You must report employee wages and withheld taxes on Form W-2, Wage and Tax Statement. Send Form W-2 to the Social Security Administration; state, city, or local tax departments (if applicable); and copies to the employee. You also need to keep a copy for your records. Do not send Form W-2 to the IRS.
Fill out Form W-2 for each employee who worked for you in the year. You also need to send Form W-3, Transmittal of Wage and Tax Statements, to the Social Security Administration when you send Forms W-2.
Independent Contractor vs. Employee Checklist
Being unable to decide whether your worker is an employee or independent contractor can result in penalties, fees, or even lawsuits. So, how do you spot the differences? Use this checklist to guide your classification.
According to the Department of Labor’s “economic realities test,” there are six general factors that can help you determine a worker’s status. Ask yourself these six questions to get started.
- How integral is the individual’s work to my business? You need to consider whether the worker’s duties are important to the business, if they play a part in the production, selling products, or performing services, and whether they perform work that is considered primary. A worker whose work is an integral part of the business is generally an employee. For example, a restaurant chef would be an employee because their work is essential to production. But if you hire someone to renovate the restaurant, they would be an independent contractor because their work is not primary to production.
- Does the worker’s managerial skill affect their opportunity for profit and loss? Determine whether your worker has the ability to hire or manage other workers and whether that management impacts the worker’s profits or losses.
- How does the worker’s investments in equipment compare to my own? If the worker invests in their own equipment, the general rule of thumb is that they are independent contractors. Although employees can invest in equipment to do their jobs, you also provide and invest in equipment for them. You need to compare the worker’s investment in equipment relative to your own investment in the equipment that they use.
- What is the worker’s skill and initiative like? If the worker uses certain skills and initiative demonstrating that they are exercising judgment for their own business, they are most likely an independent contractor. And if the worker is not economically dependent on you, they are an independent contractor. Employees also use their skills and take initiative, but they are dependent on you and their skill/initiative does not reflect that they are working for themselves.
- How permanent is my relationship to the worker? Generally, independent contractors are temporary workers. Although you might use their services in the future, they are not permanent additions to your team. Employees are hired on an indefinite basis, meaning they will stay on with you until they are terminated.
- How much control do I have over the worker’s decisions? Employees typically do not control their pay, work hours, or work they perform. Independent contractors, on the other hand, can set their own pay, choose their hours of work, and decide how they want to start and complete a project. This factor can be tricky, though, because employees can also work independently and exert control over their jobs.
Still Can’t Decide?
If you are having a tough time determining whether a worker is an employee or independent contractor, turn to the IRS. The IRS provides a common law (20-factor) test to help you decide, including factors like the right to discharge and supervision. And, you can reference the IRS’s common law rules divided into three categories (Behavioral, Financial, and Type of Relationship) for more detailed information.
You can also file Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.
When you file Form SS-8, you must report information about your company and about the worker in question. Then, you can mail the form to the IRS.
After they receive your form, the IRS decides if your worker is an employee or independent contractor. The IRS will send you a letter with their decision. Don’t forget to make necessary changes to the worker’s classification.
Keep the following in mind to help you tackle independent contractor vs. employee challenges and responsibilities.
- Difference: As a general reminder, independent contractors are self-employed individuals who work for themselves and perform work for your business. Employees are workers who work for you.
- Taxes: Withhold taxes from employee wages. Do not withhold taxes from payments to independent contractors.
- Wage Reporting: To report wages, use Form 1099-MISC for an independent contractor and Form W-2 for an employee.
- Determination: File Form SS-8 with the IRS if you cannot decide a worker’s status.
Although deciding a worker’s status isn’t black and white, understanding key characteristics of each and familiarizing yourself with the economic realities test are important. And if need be, you can reach out to the IRS or seek professional advice to make the determination easier.