Photo by Lauren Carnes
You’ve decided you need help with your business and it’s time to pay an independent contractor or an employee to help you—so which one should you choose?
Doing your research on the difference, you’re inundated with terms like independent contractors, employees, FICA, Medicare, SUTA, 1099 and the dreaded T-word—taxes.
Interestingly, this is the one conversation I’ve had with nearly every client I’ve ever worked with. While it’s a lot easier and simpler to classify your worker as an independent contractor, not withholding taxes and benefits when they should be classified as an employee doesn’t just put an undue burden on your work at tax time.
If you misclassify a worker and don’t withhold taxes and/or benefits as you should or pay the required amounts, the IRS might come after you and your business to collect the money owed.
So not only do you have to be mindful of how to classify your worker, but you should be able to clearly establish whether they’re an independent contractor or an employee.
Knowing how critical this information is, in this article, I’ll help you:
- Decipher the difference between contractors vs. employees
- Explain the three rules laid out by the IRS to determine how your worker should be classified
- Take away some of the frustration and fear that comes with finding help for your business
First, let’s tackle the two key terms of contractors vs. employees and identify their key differences.
Independent Contractors vs. Employees—Defining Each Term
Before we can identify the differences between contractors and employees, let’s clearly define each term first to give you a better sense of what your worker(s) may be.
Independent contractors
Independent contractors are considered to be exactly as described, independent.
They’re responsible for paying their own taxes, have complete control over their hours, and determine their own location of work. They choose when, where, and how they work.
As the person hiring an independent contractor, you only need to report what you’ve paid them to the IRS at the end of the year. Even then, you only need to report what you’ve paid the contractor using a Form W-9 and Form 1099-MISC if it’s in excess of $600 for the whole year.
Example: Julie has hired Avery to be a second shooter for her photography business. Julie owns the business, and contracts Avery from time to time to help her with larger gigs.
Employees
In contrast to independent contractors, employees are not independent.
Employees are hired to work for and become a part of your business, with you dictating their hours and location of work. An employee reports to you and you control where, when, and how they work.
In this case, if you’ve determined your worker is indeed an employee, you have to withhold taxes from their paychecks and you’re responsible for paying additional taxes to the IRS based on their payroll. The reporting requirements are much more extensive for employees, not to mention that outside of payroll, you have to take care of things such as human resources, health insurance, paid time off, and more.
Example: You’ve hired Samantha as your personal assistant for your marketing business. She comes into the office three days a week, gets paid an hourly rate, and works 9 to 5 each day. When she comes into the office, you direct her on what she’s supposed to be working on and delegate each of her daily tasks.
Key Differences Between Independent Contractors and Employees
The natural inclination for nearly every small business is to treat each worker like an independent contractor, since it’s so much easier to handle and often much, much cheaper.
Unfortunately, that doesn’t fly for the IRS, state governments, and any number of other agencies/businesses that are dependent on employees or who regulate employees.
To help make it easier and clearer for businesses what the rules are around hiring independent contractors vs. employees, the IRS has created a set of guidelines to determine whether the new resource you’ve hired would classify as an independent contractor or an employee.
There are three common law rules they have in place to determine if the person performing the work for your business is an independent contractor or an employee:
- Behavioral control
- Financial control
- Type of relationship
Let’s take a closer look at each rule and provide some examples of how they might apply to a graphic design business.
#1: Behavioral control
The first rule relates to the level of control over the worker’s tasks and whether or not the business dictates their work.
Does the company control or have the right to control what the worker does and how the worker does his or her job?
- If the answer is YES, then this worker is deemed an employee
- If the answer is NO, then this worker is deemed an independent contractor
Example: Sarah is a graphic designer whose business is growing quickly. With constant influxes of new clients, she needs help updating her graphic design invoice template, staying on top of her online invoice schedules and payment reminder emails. She also needs help with some of her graphic design work and wants to outsource some of her projects.
Sarah hires employee Michael as her administrative assistant, who reports directly to her and who takes direction from her on how to conduct his job.
Meanwhile, Sarah hires graphic designer Alice as an independent contractor to take care of work for her lower priority clients. Sarah does not control Alice’s work, since Alice takes care of the graphic design work herself.
#2: Financial control
The second rule around IRS guidelines involves a rule around different financial expenses the worker may incur and who incurs those expenses.
Are the business aspects of the worker’s job controlled by the payer, such as:
- If the worker is paid via hourly rate or salary (vs. online contract or payments per project)
- Whether or not the worker’s expenses are reimbursed
- Who provides tools and equipment like a laptop, desk, etc.
Whether or not these are part of the worker’s compensation clearly establishes their role.
- If the answer is YES, then this worker is deemed an employee
- If the answer is NO, then this worker is deemed an independent contractor
Example: Now that Michael is taking care of administrative work for Sarah’s business as an employee, she is paying him an hourly wage of $16/hour, 20 hours per week. She has reimbursed him for the cost of a laptop and a desk to be able to work from home and also reimburses him monthly for the cost of HoneyBook.
On the other hand, Sarah does not reimburse graphic designer and independent contractor Alice for the cost of her Adobe Creative Suite software, since Alice has other clients and Sarah is only paying her on a per project basis.
#3: Type of relationship
Finally, the last rule around distinguishing between an independent contractor and an employee is around the type of relationship that exists between you and the worker and possible benefits.
Are there written contracts or employee-type benefits that establish a pension plan, insurance, or vacation pay? Will the relationship continue and is the work performed a key aspect of the business?
- If the answer is YES, then this worker is deemed an employee
- If the answer is NO, then this worker is deemed an independent contractor
Example: As Sarah’s graphic design business picks up, she has managed to negotiate a group insurance plan and 401(k) plan for employee Michael. She also offers him two weeks’ worth of paid vacation annually.
However, independent contractor Alice does not benefit from the health insurance or 401(k) plan, as she continues to work on a project basis and is not officially part of the company payroll and does not work regular hours for Sarah. She also does not receive any vacation time.
Making The Right Choice
When asking yourself these three questions, if you’re lucky enough to get a clear-cut answer as to whether or not your worker is an employee or an independent contractor, you’re in good shape.
However, sometimes it’s just not that clear, especially if your worker meets some of the criteria of the three rules set out by the IRS, but not all of them. If you’re still unsure about your worker’s status, the IRS advises you to look at the engagement as a whole and determine which best applies.
If you’re still stumped, then you can get a ruling from the IRS directly using Form SS-8 (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding) on whether this person is an independent contractor or employee.
The important thing to remember is that misclassifying employees as independent contractors can spell out much more serious consequences than misclassifying the other way around. The penalties are much higher than if you misclassify an independent contractor as an employee.
In the long run, you need to ensure that you’re classifying your new hire correctly so you’re meeting your tax and other financial obligations to state and local governments. If not, it could mean a lot more hassle and payments in the future.
