Independent Contractors and Employees: How They’re Different

As your business grows over time you will probably want to expand and hire people for different roles. Luckily, there are many options available for companies who need to find talented workers. As an employer, there are two main types of workers: employees and independent contractors.

What’s the difference you ask? For a new business, it’s important to know the difference between independent contractors and employees for tax purposes. The IRS takes misclassification very seriously so it is important for you to understand the difference to prevent future legal and financial issues. Here’s more information about how to classify your company’s workers so you won’t have to worry during tax season.

How Employees and Independent Contractors Affect Your Company’s Taxes

Employees are great (especially if they are productive), but they also come with significant tax obligations. As an employer, you have to withhold some of their income every month to cover their Medicare and Social Security. You also have to take out money for federal and state taxes in every paycheck. Do you plan to offer your employees health insurance and retirement benefits? That will affect their pay and taxes as well.

With independent contractors, you don’t have to withhold taxes. Since they are independent and working for you for a short-term, they are responsible for paying their own state and federal taxes using the money they earn.

Do you have an employee or an independent contractor?

The Common Law Test is a typical test used by the IRS to divide the two groups and decide which type of worker a person is. The test focuses on three different categories: money, relationship, and behavior. Based on how the worker is compensated, and their relationship and power dynamic with the employer and their behavior, the government can decide if a worker is an employee or independent contractor.

Here are some sample questions you could ask under the Common Law Test:

1. Who has financial control of when the worker receives payment? The employer or the worker?

2. Does the employer provide equipment and tools for the worker or do they use their own?
3. Does the employer control of how the work is done or can the worker complete the task in their own time with their own discretion?
4. Is the work a core part of the business?
5. How long has the worker had a business relationship with the employer?
6. Is there a contract?
7. Does the worker receive benefits like sick and vacation pay?
8. Does the employer pay for the worker’s health insurance?

Overall, when a worker uses their own tools to complete a job and can complete it under their own discretion, they are most likely classified as an independent contractor. Independent contractors typically have more autonomy and can complete their work in any location. When employers control what the worker does, provides their equipment and dictates how they should complete their job, the IRS typically classifies the worker as an employee.

There are harsh consequences if the IRS believes your company willingly misclassified an employee as an independent contractors for tax advantages. You may have to pay fees and suffer other penalties. It’s important that you work with a quality CPA, like ourselves, so that can help you distinguish between the two.

Please contact us today to learn more about our financial services. We would love to help you sort out the tax status of your workers, and even offer other professional services including strategic business advice. At GMLCPA, we value helping small and local businesses be the absolute best they can be.