Learn how to tell the difference between the two and make the best decision for your business.
Whether you’re at the point in your business journey where you’re ready to hire help, or you’re just hoping to be prepared for when you do get to that point (ooh, prepared, my favourite adjective), you’ve got to give a thought to whether you’re hiring an independent contractor or an employee.
The distinction is sooooo important, because whichever you choose, it means different things for you taxwise. If you make a mistake, you might be paying for it later—but don’t worry, I’m here to help! Keep reading to find out the difference between the two, how you can choose which to hire, and what your decision will mean for you in terms of taxes.
Independent Contractor Status
It’s critical that you figure out the working relationship between you and the person you hire.
An independent contractor (with independent contractor status in the eyes of the IRS) is responsible for paying their own taxes. That means you, as a business owner, won’t have to withhold taxes from them since they’ll be paying them themselves. The money independent contractors earn while working as an independent contractor is subject to Self-Employment Tax (Self-Employment Tax includes taxes for Medicare and Social Security). But, even though you won’t have to withhold taxes for the independent contractor, you still need to report the amount you pay them each year on a Form 1099-MISC.
Independent contractors can include dentists, doctors, veterinarians, lawyers, contractors, subcontractors, accountants, auctioneers, or public stenographers who, as the IRS states, “are in an independent trade, business, or profession in which they offer their services to the general public”. Basically, they’re people who have control over what work will be done and how it will be done, without a supervisor or employer directing how the services will be performed.
Someone who performs services for you is considered your employee, with employee status, if you control what work will be done and how the work will be done. I touched on this a little above regarding independent contractors. They have the freedom to decide what work will be done and how, unlike an employee.
Hiring an employee has tax implications. It will mean you will have to withhold employment taxes, which includes social security and medicare taxes, federal income tax, and federal unemployment tax.
Social Security and Medicare Taxes
As an employer, you’ll have to withhold part of the social security and Medicare taxes from your employee’s salary and pay a matching amount. To find out how much you’ll need to hold back, use your employee’s W-4 and these IRS publications: Employer’s Tax Guide and Employer’s Supplemental Tax Guide.
Federal Income Tax
You’ll have to hold federal income tax back too, and to figure out how much to withhold, use your employee’s W-4 and The IRS publication Federal Income Tax Withholding Methods.
You will need to deposit the taxes you hold back. You can do so using Electronic Funds Transfer (EFT). For more information, see section 11 of the IRS Employer’s Tax Guide.
Federal Unemployment Tax
This is a tax you pay yourself, from your business. Do not withhold taxes from your employee to pay this tax.
The Right to Control Test: How to Tell an Independent Contractor from an Employee
So, we’ve established that the biggest difference between an independent contractor and an employee is the degree of control they control over their work. The test you can use to determine this is called the “right to control test”.
The tests has three parts:
- Behavioral: who has control over what the worker does and how they do their job?
- Financial: who controls when and how the worker is paid? Are expenses reimbursed? Who provides the worker with supplies needed to do the work?
- Type of relationship: is there a contract in place that sets out employee-like benefits? For example, contracts regarding pension plans, vacation and vacation pay, insurance? Is the worker expected to continue in their role?
If you’ve thought long and hard about this, you should be able to determine whether your relationship with the worker in question is independent contractor-like or employee/employer-like in nature.
If you’re still stumped after doing the right to control test, you can file a Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. Filing this form will allow the IRS to make a determination, but keep in mind the process can take at least 6 months.
Here are some examples:
Robert is a salesman who does work part-time in a store that sells home appliances. He sees customers every day and helps them in choosing the correct appliance for their home. He uses selling tactics he was taught in his training by his manager and processes purchases. He is paid biweekly as stipulated in his contract. Robert is an employee.
Sally is a copyeditor. She is professionally trained and is contacted by Laura to take on some copyediting projects. Laura has 5 books that she wants Sally to copyedit by November 2, 2021. Sally chooses to work on the books whenever she likes, knowing that as long as she has her work completed by November 2, she’s in the clear. She knows the job and does not need Laura to supervise her. Sally is an independent contractor.
The Consequences of Misclassifying Your Worker
The IRS is pretty serious about this stuff. If you’ve classified an employee as an independent contractor (and you have no reasonable basis for classifying them that way), you may be held liable for employment taxes for that worker.
I wouldn’t wanna mess around with the IRS, would you? So it’s crucial that you classify your worker correctly.
To Hire an Independent Contractor or Employee? Making the Best Choice for Your Business
The choice whether to hire an independent contractor or employee totally depends on the work you need done and what kind of control you desire over when and how it gets completed.
You might want to hire an independent contractor if:
- you have a fixed-term project you need completed with start and end dates
- the work you need done requires little supervision
- you want your work/project completed by a professional who will give you the end result you desire without much direction
- the work/project isn’t necessary for your business to run (for example, a graphic designer who’s designing ads for you, an office cleaner, or an IT service).
You might want to hire an employee instead if:
- the work is necessary for your business to run and is not an “extra” job outside of your main business plan/mission
- you feel the need to control when and how the work gets done
- your supervision over the worker is necessary
- the work is needed long-term instead of for a fixed-term.
If, after making the decision, you come to the conclusion you would like to hire an independent contractor, you’ll need to have a solid contract in place with them.
A contract can help you avoid nightmare clients and save you money and headaches.
Artful Contracts has an easy-to-use Independent Contractor Contract Template to get you started that will help you iron out all aspects of your project, including the tough stuff like who owns the work once it’s completed and what happens if someone doesn’t hold up their end of the contract.
The contract template is perfect for small business owners, solopreneurs, and entrepreneurs who are looking to hire any kind of contracted professional. It can be easily tailored to virtual assistants, admin support, copywriters, marketers, and any other part-time workers.
For other ways to protect your money and business, watch the free masterclass: How to Legally Protect & Grow Your Online Business So You Can Keep More of the Money You Make