Every employer needs to be aware of the hiring choices they are making and how they can influence their business. Knowing the difference between a full-time employee and an independent contractor isn’t always easy to determine, not for the employer, and sometimes not even for the employee. However, when it comes to taxes and the IRS, that difference carries a lot of weight. Facing misclassification risk can cause significant disturbance, so to avoid any confrontation with the labor law, make sure you have all the information.
Most significant differences between independent contractors and employees
The Internal Revenue Service doesn’t have a strict set of rules that determine the employee’s status, which poses a challenge for every employer. However, they have a list of guidelines that help them decide every particular case, specifically for tax purposes. In their eyes, every person hired is viewed as an employee. That means that the employer is responsible for providing all sorts of benefits, such as healthcare, and paying all the necessary taxes. That gives them the right to control hours, office space, and employee’s schedule.
When it comes to independent contractors, the situation is the opposite. The independent contractors have the right to control and choose the conditions and don’t depend on the employer in any way. They are responsible for filing taxes and taking care of their own hours, health insurance, vacation, and other contributions. The easiest way to understand it is that a higher degree of control comes with more significant responsibilities and taxes. Now, let’s dive into particulars.
How can I quickly determine the status of my employee?
Before we dissect all the IRS guidelines, let’s see the easiest way to understand this difference from the employer’s perspective. Let’s say you are a small business owner who has a restaurant. Everyone in charge of the core business - preparing and serving food - will most likely be considered an employee. If you are responsible for their training, shifts, schedules, and vacation, they are certainly employees. However, suppose you hire someone on a less long-term commitment basis to be in charge of your restaurant’s interior design, giving them freedom and autonomy. In that case, they can be considered independent workers. You aren’t responsible for them; you only hire them for a particular service, one that isn’t essential to your core business.
On the other hand, let’s say that you own a marketing agency. Your designers, creatives, copywriters, and videographers - they are your core business employees, essential to your business survival. You will train them, give them equipment, and control how they complete their assignments. It will be quite a daunting task convincing the federal government they are independent contractors, although their positions usually are. However, you will have no issues classifying your accounting, human resources, or finance like that, conditional that other criteria are met as well.
This staffing issue will inevitably generate conflict. If you aren’t sure how to proceed, it is best to collaborate with the said employee and reach a compromise. From a legal point of view, an employer can’t misclassify a worker even if they agree. Your obligation isn’t only to them; it’s to the federal government as well.
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What are the employers’ obligations when hiring a full-time employee?
For every person you hire, regardless of their position, there is a list of obligations. First and foremost, employers are responsible for withholding taxes from paychecks. Employees (very often called common law employees) also receive benefits, such as social security, pension plan, medicare, severance packages, workers' compensation insurance, and unemployment insurance (or unemployment compensation). All of this is covered by the Federal Insurance Contributions Act (FICA taxes), and there are written contracts signed by both parties. Company right to control is much higher; employee status comes with benefits but also with less autonomy.
Health insurance is also something covered by this type of relationship, regardless of the employee works full-time or not. Another obligation is the minimum wage - Employers can’t pay their employees less than that. However, the law doesn’t protect freelancers and independent contractors in such a way.
Other criteria for determining worker status is vacation pay. If the person you hired determines their own vacation time and doesn’t receive compensation during that time, they are not an employee.
Another important distinction between independent workers and employees is that the Fair Labor Standards Act protects employees. Some of the issues this act is handling are child labor, minimum wage, and overtime.
What degree of control can you have over your independent contractor?
An Independent contractor agreement covers the relationship you create with this type of worker. Unlike employees protected by the labor law, the Self-Employed Contributions Act (SECA) regulates self-employed workers. Misclassifying someone is always a risk. Still, it is reasonably easy to determine if a person hired isn’t an employee in most cases. Independent contractors aren’t controlled in any way by the employer; they only have a particular task to perform. They don’t possess a significant investment for the employer - they have their equipment, use their own tools, do their training, and usually work as freelancers or independent contractors for multiple employers. The level of control is insignificant, although the employer can still control the result of the work. Contractor status can vary with every project, and conditions can change. However, the contractors are not eligible to receive any employee benefits or perks.
Minimize the misclassification risk with the IRS' three-questions test
Since there is still a lot of confusion regarding differences between the independent contractor and employee status, the IRS has created a test that helps any business owner. To determine if the person you hired is an employee or not, you should start by answering these three questions.
Behavioral Control: Is the employer controlling the behavior of the worker?
Independent contractors are self-employed. That means that the employer has control over the result of the work, but not over the work itself- hours, vacations, tools, and office space used. They are all either controlled by the employee or acquired by them. Simply put, there is very little to none behavioral control over them and over how they will perform their tasks. In this case, business expenses are significantly lower since the employer only pays for the result and doesn’t have any additional costs.
Financial control: Does the employer have financial control over the worker?
If you choose to hire an independent contractor, you determine a fee by the hour or by the project. There are no additional expenses, and there are no guarantees that the required services will be needed more than once. There is no tax withholding, cost reimbursement, nor any type of financial benefit, except the previously agreed fee for the job done. In some cases, the independent contractor is allowed to receive a bonus, if the contract states so in the contract. Independent worker can also choose to have several employers or subcontractors to perform the work.
On the contrary, employees are entitled to a salary, a guaranteed income paid to them regularly. Employment relationship protects both parties, and the U.S. Department of Labor regulates the relationship.
Working relationship: What kind of relationship will the employer have with the worker?
Another critical aspect of determining your new hire’s status is the kind of relationship you have with them and how long it will last. Permanency of the relationship is a significant factor when it comes to misclassification. The more stable, steady, and long-term the relationship is, the more likely the Internal Revenue Service is to view that hire as an employee. Independent contractors are usually hired on a temporary, short-term basis.
In addition to this, if your new hire is vital to your core business, they will probably get an employee’s status.
Tax forms requirements for working with independent contractors
The differences mentioned above, criteria, and potential issues all serve to determine who is responsible for paying taxes and which ones. It is wrong to assume that no taxes are being paid in the case of hiring an independent contractor. They are, just not by the employer.
If a business owner decides to hire a freelancer or an independent contractor, they need to collect the following tax forms:
- Form W-9, for independent contractors who reside in the United States
- Form W-8BEN (for individuals) and W-8BEN-E (for entities) who reside outside of the United States
- Form 1099-NEC (previously a part of Form 1099-MISC Box 7), for every independent contractor they hire who is paid more than $600 in a given tax year.
On the other hand, every independent contractor is responsible for filing their taxes, including the self-employment tax and income tax. However, there are cases where independent contractors can deduct their taxable income. If they fail to comply with tax regulations, their employer isn’t accountable for the debts.
In the case of hiring an employee, the employers need to file a Form W-2. Employment law requires the employer to withhold taxes and pay certain benefits.
Although the Uber controversy is the one most talked about, many other businesses have had their fair share of employee misclassification cases. Contrary to popular belief, big corporations aren’t the only ones who have tried to get out of paying the necessary payroll taxes, among others. Small business owners have also had meaningful encounters with the IRS.
Economic realities have caused this issue to be so present across industries. Every business owner knows they need to be a responsible taxpayer, but some choose to avoid the responsibilities to reduce the costs and keep their business afloat.
However, exposure to misclassification risks not worth it ultimately, since the consequences can be severe, and quite costly. If the IRS determines that an independent contractor should be an employee instead, their response is very standard. The business will be required to pay back what they are owed, including Medicare taxes, social security, income taxes, and taxes for unemployment. In this case, the payer is only the owner; the employee carries no responsibility.
It is important to note that a business can’t hire someone as an independent contractor if they don’t fit the criteria, even if the parties involved agree on the worker's status. The obligation is towards the state, not towards the hire.
In some cases, it might generally be challenging to determine the status. To assist in this matter, the IRS has created a particular form to ease the process. If you aren’t sure what to do, you can file Form SS-8 to the IRS and describe the concrete example you are struggling with. Remember that this form can’t be used for hypothetical situations, only ones that are happening. If you are still unsure of your worker's employment status, you can always consult a law firm.