Many small and medium sized businesses face the issue of when someone is an employee and when they are an independent contractor. It is critical that owners correctly make this determination as there are consequences if someone is misclassified. Click the orange circle to listen to the podcast.
SO WHAT ARE THE MAIN DIFFERENCES BETWEEN AN EMPLOYEE AND AN INDEPENDENT CONTRACTOR?
As an employee:
- Paid by the hour or salary on a Form W-2
- Employer withholds SS, Medicare, federal and state taxes
- Employer pays part of the employees Social Security and Medicare
- Employer pays the unemployment and workers compensation insurance
As an independent contractor:
- Paid by the project on a Form 1099
- Responsible for payment of their Social Security and Medicare and liability and workers compensation insurances
- Pays their taxes via quarterly estimates
- Is not eligible for unemployment compensation
In summary, as an employee you are basically paid by the hour and as an independent contractor you are paid by the job. Also, as an employee your employer withholds Social Security, Medicare, federal and state taxes and they also pay a portion of your Social Security and Medicare taxes. As an independent contractor, you are responsible for paying both halves of that Social Security and Medicare, which is often called self-employment tax, along with your own worker’s compensation insurance. The other thing is that as an independent contractor you are not eligible for unemployment.
HOW DOES AN EMPLOYER DETERMINE THE CORRECT CLASSIFICATION?
The IRS provides some guidance, but all determinations are based on facts and circumstances. If you look at it an employee usually works exclusively for one company, the company provides the tools, the company tells the employees what to do, the company sets the working hours, and the company gives a person vacation and pays the expenses. If you are an independent contractor, you work for many companies, you provide your own tools, you decide how the work is completed, you set your own working hours and you may even hire someone else to help you out with the job. Those are the kind of things that are different between an employee and an independent contractor.
WHAT CAN AN EMPLOYEE DO IF THEY FEEL LIKE THEY ARE BEING MISCLASSIFIED?
- Workers who believe that they are misclassified can file a form with their return to figure and report the employer’s share of uncollected tax.
- Even if they previously agreed, former employees can file this form and cause issues for their former employers.
Here is the scenario that happens. You hire an employee and everyone agreed that they are going to be an independent contractor, but later on you have a falling out, and now this person says they feel as if they were actually an employee not an independent contractor. So what that employee does is file a form with their return saying they are going to only pay their half of their Social Security and Medicare because they believe they were an employee rather than an independent contractor. So even though the employee and the employer previously agreed, this can cause problems depending on how the situation works out.
WHAT ARE THE BENEFITS OF BEING AN EMPLOYEE VS. AN INDEPENDENT CONTRACTOR?
Some of the benefits of being an employee is that you obviously get the benefits of the company, where if you are an independent contractor you have to supply your own benefits. The biggest thing is how you pay your taxes. As an employee you pay half of the Social Security, half of the Medicare, and as stated before, your employer actually takes off for your federal and state withholding. As an independent contractor you have to pay that full part of the self-employment tax, essentially both halves of Social Security and Medicare, which is like 15.3%. You also have to make sure that you pay in your own federal and state taxes via quarterly estimates.
WHAT ARE THE CONSEQUENCES FOR BEING MISCLASSIFIED?
- Company may be liable for employment taxes (SS, Med, unemployment).
- Penalties and interest.
- But employers can apply for a Voluntary Classification Settlement Program that can provide them with the opportunity to reclassify their workers with partial relief from federal employment taxes.
- Federal and state agencies have put a greater emphasis on this issue in the recent years. If your business were to get audited, they will ask for a list of your independent contractors.
A Company can be liable for those back taxes that they didn’t pay, whether that be Social Security, Medicare, or Unemployment. Because you didn’t pay those timely, there is also some penalties and interest that can be applied. If there is an employer that feels that they treated this person as an independent contractor for a number of years, but they really should be treated as an employee, the IRS does have a voluntary classification settlement program that can help bridge that gap between taking that independent contractor and converting them essentially into an employee. This will allow partial relief from some of the federal employment taxes and some of the penalties. One thing that we found is that federal and state agencies have really put a greater emphasis on this issue in recent years so if your business were to ever get audited, even if it wasn’t for this issue, one of the things that they are going to ask for is a listing of your independent contractors because they want to see the determination as to whether this person should be an employee or an independent contractor.