December 12, 2019 Taxes en_US If you misclassify workers, you could land in hot water with the IRS and the DOL. So learn the difference between an independent contractor vs. employee. https://quickbooks.intuit.com/cas/dam/IMAGE/A1pEyrAfI/2affaab51e18609cadc9e00e6aea66e6.jpg https://quickbooks.intuit.com/us/article/employee-vs-independent-contractor-which-is-correct/ Independent contractor vs. employee: A small business owner's guide
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Independent contractor vs. employee: A small business owner's guide

By Chris Scott December 12, 2019

Congratulations! You’re a small business owner who is ready to expand your business and hire your first worker. If you’ve never done so before, you may find yourself quickly overwhelmed with the process.

Before you hire your first worker, you must understand the difference between an independent contractor vs. employee. Doing so will dictate how your hiring process goes. It’s the first decision you should make before you do anything else, including posting an ad for the position.

Not only will the decision impact your business financially, it will also affect you and your company legally. Misclassifying workers could result in up to one year in prison, along with a $1,000 fine for each misclassified worker.

In this article, we’ll cover everything you need to know regarding independent contractors vs. employees. Not only will we outline the differences between the two, we’ll also highlight some of the pros and cons of hiring each type of worker. By the end of this article, you should have a clear understanding of which is best for your small business.

What is an independent contractor?

According to the IRS, “The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done.”

Employers can control the actions of employees, but they can’t necessarily control the actions of independent contractors. Independent contractors have the right to control the work that’s done and how it’s completed.

Perhaps a more straightforward way to word this is that independent contractors are individuals who provide services to other businesses. They have a degree of control, such as financial control over the rates they charge, as well as the ability to set their own hours.

How you pay independent contractors

If you hire someone who is self-employed, you can pay them using IRS Form 1099-MISC. You’ll need to submit a 1099-MISC for these individuals if they earn more than $600 working for your business. Business owners will need to submit this form at the end of the year, no matter when during the year they pay the contractor.

For instance, imagine you hire an independent contractor to write a website for you. The individual works 40 hours per week in January and February, and bills you accordingly. You promptly pay the individual. However, all you are doing is providing them with payment. You’re not completing Form 1099-MISC at this time.

Then the individual jumps back onto the project in June for some routine maintenance. The individual works 20 hours, and you pay the person promptly. Again, you won’t submit a 1099 at this time.

At the end of the year, you’ll complete the 1099. You need to do so no later than February 1 of the following tax year. If you fail to do so, you’re subject to IRS penalties. Not only will you need to give a copy to the contractor, you’ll also need to provide a copy to the IRS.

Financial and tax implications of hiring independent contractors

Independent contractors are unique because they’re required to pay the entirety of their tax burden. This is known as the self-employment tax, which includes both Social Security and Medicare taxes.

As we’ll detail below, employers are required to pay half of these taxes on behalf of their employees. However, this is not the case with contractors. Contractors must pay the entire self-employment tax, which is 15.3%.

So, let’s say you pay a worker $100 an hour. If you’re paying the contractor, you’ll pay the $100 and be done. The contractor is then responsible for paying $15.30 in taxes. If you’re paying an employee, you’ll pay the individual $100 for the hour worked. You’ll then pay the government an additional $7.65 in taxes. The employee must also pay $7.65 in taxes. So working with the independent contractor, you have saved $7.65.

Furthermore, employers are not required to withhold certain funds or pay into mandatory programs. For instance, employers don’t have to pay workers’ compensation for contractors. They also don’t have to pay unemployment taxes or health insurance.

Those carrying a contractor status typically don’t receive employee benefits either. This includes things such as a 401(k) and paid time off. Technically, you’re not required to offer these benefits to part-time employees either, although more and more employers are doing so. According to the Bureau of Labor Statistics, two-thirds of all employees, including both full and part-time workers, have access to medical care.

Lastly, contractors tend to need to supply their own tools and materials. Programmers, for example, may need to provide their own laptops and computers. Contractors also don’t receive business expense reimbursement.

So from this perspective, independent contractors can be significantly cheaper than hiring employees. However, know that savvy independent contractors will work this into their rate. You may need to pay a contractor more per hour than you would an employee, which could mitigate what you save on taxes and benefits. But you also won’t have the burden of having to deal with income taxes and other expenses.

What is an employee?

An employee is an individual hired by an employer to perform a specific job. Unlike an independent contractor, an employee does not have the right to control the type of work they’re doing or when they’re doing it.

Defining the true nature of an employee relationship can be tricky. The Department of Labor outlines that a written contract is not what determines employment. Instead, under the Fair Labor Standards Act, there are economic realities that must be met. As defined on the Department of Labor website, facts significant to establishing the employee relationship include:

  1. The extent to which the services rendered are an integral part of the company’s business
  2. The permanency of the relationship
  3. The amount of the alleged contractor’s investment in facilities and equipment
  4. The nature and degree of control by the business
  5. The alleged contractor’s opportunities for profit and loss
  6. How much the employer needs to develop, train, and market the employee (with business cards, etc.)
  7. The degree of independent business organization and operation

There are a couple of other things, especially from a financial perspective, that can help further outline what an employee is.

How you pay employees

There are a couple of things to consider when paying employees. First and foremost, employees are subject to minimum wages. Not only do minimum wages exist at the federal level, but at the state and local levels as well. Make sure you’re paying your employee the minimum wage for your area.

Employers define how and when they’d like to pay employees. Many small businesses elect to pay employees on a bi-weekly basis, although weekly or monthly payments are also possibilities.

When the end of the year arrives, you’ll need to submit an IRS Form W-2. The employer is responsible for ensuring that they complete this form in a timely fashion. This form reports relevant information, such as earned wage and tax withholding amounts, to the IRS and to the employee.

Financial and tax implications of hiring employees

As mentioned, employers are required to pay employees a minimum wage. Employers can choose between setting hourly or salaried rates.

In addition to paying employees, employers must also concern themselves with withholding taxes. Whereas independent contractors are responsible for paying the entirety of their Social Security and Medicare tax burden, such is not the case with employees. Employees only pay half, which is equal to 7.65%. Employers must then pay the other half. We touched on this in our example in the previous contractors section.

In addition to these payroll taxes, employers are also responsible for providing things like health insurance and paying for things like unemployment insurance. These benefits are required for full-time employees and optional for part-time employees.

So employees could be more expensive than contractors in this regard. Why choose the employee structure then?

For one, there’s a healthy employee relationship that can exist between the employer and the worker. Working alongside each other daily is much more likely with employees. Employees are more likely to buy into the company culture and understand why they’re there in the first place.

Additionally, employers have a bit of behavioral control over employees that doesn’t exist with contractors. For instance, employers can mandate things like the dress code and the hours worked. This tends not to exist when working with contractors.

Independent contractors vs. employees: Pros and cons

In addition to the legal and financial ramifications, there are a few other pros and cons that you should consider when comparing independent contractors vs. employees.

Contractors

One of the biggest pros with hiring independent contractors is the staffing flexibility that comes with it. This could be particularly beneficial for business owners in, say, the tax industry that experience busy periods followed by less busy periods. Hiring contractors could be an excellent short-term solution to meet your needs.

Imagine a business owner has an influx of tax returns to file by April 15. The owner could hire contractors and pay them a flat-rate for each return that they file.

Another pro is that there isn’t much training involved. By bringing a contractor on board, you’re hiring an expert to complete a project. You shouldn’t need to spend much time training them. Contractors come without the commitment often required when hiring employees. Hiring a new employee is an investment. Not only is there an onboarding period, but the goal is to see the employee grow and take on more responsibility over the course of a few years.

The most evident con is that it’s tough to get contractors to buy into your company culture and what you’re building. Workers will come and go more frequently. You’ll also have less control over these workers, and it could be challenging to maintain quality standards.

Employees

Employees are advantageous because you have a better idea of what you’re going to get. You generally know when employees are going to be at work because you set the schedule. You are also guaranteed more continuity in your workforce. You should save money on job searches, as employees tend to be with companies for years rather than months.

On the other hand, employees are expensive. Employees tend to require things like benefits and vacation. There is also significantly more paperwork involved as you have to worry about things like withholding taxes. You’re also responsible for all training and materials for employees, including any relevant licenses and certificates.

Which is best for your small business?

MBO Partners estimates that by 2027, 58% of American workers will have had some experience working as an independent contractor. In the coming years, small business owners will have more and more access to freelancers and independent contractors.

However, does this mean that you should elect to hire independent contractors for your business? There’s no clear-cut answer. Take time to weigh the pros and cons of each type of relationship.

Hiring a worker is a significant investment, so you’ll want to make sure you make the right selection for your company. If you’re confused, consider consulting a trusted attorney, accountant, or tax professional to clarify the issue further and ensure you understand the impact the hiring will have on your small business.

Also remember that the misclassification of an employee’s status could carry significant legal ramifications. Consulting a trusted professional will ensure you follow employment laws. It may seem daunting now, but with a bit of due diligence and research, you’re sure to find the best type of worker for your company.

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Chris Scott is a digital marketing consultant and freelance writer. He enjoys writing about personal finance and saving. He graduated from the University of Maryland with a degree in Finance and currently resides in Boston, MA. Read more