Have you gotten to the point in your business where it might be time to hire some help? If so, it’s important to understand and correctly apply the rules for classifying a worker as an employee or an independent contractor. This classification is really important because it determines if you as an employer have to withhold income taxes and pay Social Security, Medicare taxes and unemployment tax on wages paid to an employee. If the worker is identified as an employee (W2), then you are required to withhold employee income tax and pay payroll taxes. On the other hand, you are generally not required to withhold taxes and pay payroll taxes for independent contractors.
Generally, an individual is an independent contractor if the payer has the right to control or direct only the result of the work, not what will be done and how it will be done. Small businesses should consider all evidence of the degree of control and independence in the employer/worker relationship. Whether a worker is a contractor or employee depends on the facts in each situation.
Here are the key differences between the two classifications:
1099 Independent Contractors
- Control and Independence:
- They have more control over how and when they perform their work.
- They are typically hired for a specific project or time frame.
- Taxes:
- They are responsible for handling their own taxes, including self-employment tax.
- Employers do not withhold income taxes or social security/medicare taxes from payment to contractors.
- Benefits:
- They are not entitled to employee benefits such as health insurance, retirement plans or paid time off.
- Expenses:
- They are generally responsible for their own work-related expenses.
- They invoice the employer for their services.
- Liability:
- They are responsible for their own liability insurance.
- Employers are not typically liable for the actions of independent contractors.
W2 Employees
- Control and Supervision:
- Employers have more control over when, where, and how employees perform their work.
- Employees may work set hours and follow company policies.
- Taxes:
- Employers withhold federal and state income taxes, Social Security, and Medicare taxes from employees’ paychecks.
- Employers also contribute their share of Social Security and Medicare taxes.
- Benefits:
- They are often eligible for a range of benefits including health insurance, retirement plans and paid time off.
- Employers may contribute to or fully cover these benefits.
- Expenses:
- Employers typically cover work-related expenses for employees such as equipment, tools and travel expenses.
- Liability:
- Employers are generally liable for the actions of their employees while performing job-related taxes.
You should ask yourself these three questions before deciding on how to classify the person:
- Behavioral Control:
- Do you control how the work is done? More control suggests and Employee (W2) relationship.
- Financial Control:
- Does the worker have a significant financial investment in their work? Independent contractors often have more financial independence.
- Relationship:
- Is the work performed a key aspect of your business? An ongoing, integral relationship suggests and employee relationship.
Legal and Regulatory Implications:
Misclassifying workers can lead to legal and financial consequences for employers. Independent contractor misclassification can result in penalties for failing to withhold taxes and provide benefits.
It’s crucial to carefully assess the nature of the work relationship and consult legal or tax professionals to ensure you are compliant.
