Taxes for Employees vs. Independent Contractors Text Size:

If you're like many business owners, you pay workers to do various jobs or tasks in order to run your business successfully. Answering phones, filling sales orders, and fixing and maintaining the work premises are just some of the things you might pay other people to do for you.

An important question for you is: Are the workers "employees" or "independent contractors"? There are big differences between the two types of workers, especially when it comes to your responsibilities and obligations for employment taxes. You could face big fines and penalties from the Internal Revenue Service (IRS) if you mistakenly treat a worker as an independent contractor rather than an employee.

To protect yourself, you should be able to tell the difference between these two types of workers, as well as what you need to do for their employment taxes.

Independent Contractor or Employee?

Generally, an independent contractor is "self-employed." She's in business for herself and agrees to perform some job for you, in her own way and using her own tools or equipment. You have the right to tell her which job to do, but you generally can't tell her how to do it. For example, you can hire an independent contractor to clean your office building, but you usually can't tell him exactly how to clean it.

An employee, on the other hand, is a worker that you can hire, fire, and control the way he performs his job or task.

Sometimes, it's not easy to figure out if a worker is an employee or an independent contractor. For the most part, the critical factor is how much control you have over him and various aspects of his work. The IRS looks at numerous factors when determining if your worker is an employee or independent contractor. These include:

No one factor is more important than the others, but the more factors that the IRS finds the more likely it is that the IRS will consider a worker to be an employee rather than an independent contractor.

Why the IRS Cares

For federal tax purposes, the differences between independent contractors and employees are critical.

Employees

For employees, you have numerous responsibilities for employment taxes, such as:

• Withholding federal income taxes from your employee's paychecks. You should have your employees complete a W-4 Form, which tells you how much to withhold. If the employee doesn't complete one, you should withhold income taxes anyway
• Withholding Social Security and Medicare taxes from the employee's paychecks. These are commonly know as Federal Insurance Contributions Act (FICA) taxes
• You have to pay some FICA taxes out of your own pocket
• You have to pay Federal Unemployment Tax Act (FUTA) taxes. Again, this is out of your pocket; your employees don't pay it and you can't withhold it from their paychecks
• Each year, you have to give your employees a W-2 Form, which tells the employee things like how much she was paid for the year and how much tax you withheld

In addition, if you have employees, you likely have state and local taxes to worry about, such as:

• Withholding state and local income taxes
• State unemployment taxes

Independent Contractors

You don't have nearly as many tax obligations if your workers are independent contractors. Generally, you don't have to withhold federal, state, or local income taxes; Social Security and Medicare (FICA) taxes; or federal (FUTA) or state unemployment taxes. Also, you don't have any out-of-pocket expenses for FICA or FUTA taxes, and you don't have to give independent contractors a W-2.

You do have some responsibilities, however. Generally, if you pay an independent contractor $600 or more to do work for you during the course of the year, you need to fill out a Form 1099-MISC. You need to file that form with the IRS, and you have to give the independent contractor a copy as well.

Having Trouble?

If you can't determine if a worker is an employee or an independent contractor, the IRS has a worksheet where you fill in information about the worker and the IRS will determine for you if the worker is an employee or independent contractor. If you're not comfortable doing that, then you should talk to your tax adviser or tax lawyer. If you make a mistake and treat an employee as an independent contractor, the IRS can make you pay all of that worker's employment taxes, and maybe even a fine, as well.

Questions for Your Attorney

• When I hire independent contractors, I make sure they sign a contract stating they are in fact independent contractors and not employees. There's no way the IRS can claim that they're employees, right?
• Should I avoid using the same independent contractor for all of my needs? By using him all the time, doesn't that make him my "employee?"
• I forgot to send an independent contractor a 1099-MISC. If she gets audited, can I get in trouble? Should I send her one now?
• What if I disagree with someone who does work for my business about her status as an employee or an independent contractor? Who decides?

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