Vanessa Lucey of Lucey Accounting explains the difference between contractors and employees.
A subcontractor (independent contractor) can work for others, can often set their own work hours, and often provides their own tools. On the other hand, you have few reporting or tax responsibilities for independent contractors. The payroll responsibilities for an independent worker are significantly less than for an employee. Let’s look at some Pros and Cons.
What are independent contractors and employees?
You enter into a contract with an independent contractor to do a specific role or complete a specific task. Contractors may set their own hours and use their own tools. They may even work for more than one business. Since they are self-employed, you do not withhold taxes from their paychecks, they pay their own taxes. They also provide their own benefits/insurance.
An employee is hired by your business under an employment agreement. You withhold taxes from their wages, train them, pay employment taxes for them, and may provide benefits. Because of this, you have more control over your employees. You can dictate what they work on and when they work.
How do 1099s and W2s play into this?
Simply put, W2s and 1099s are two separate tax forms for two different types of workers. If you are independent contractor you get a 1099 form. If you are an employee you receive a W2. As a W-2 employee, you have payroll taxes automatically taken out of your paycheck, and then they are paid to the government through your employer. If you are a contractor you are responsible for calculating your own payroll taxes, and then submitting tax payments to the government on a quarterly basis. The independent contractor tax rate is 15.3%, and that includes Social Security and Medicare. But it is a little more complicated than this. Income up to $118,500 is subject to Social Security, and all your income is subject to Medicare taxes.
Should independent contractors receive a 1099 when their income is $600 or more in a year? Yes. You can find both forms on the IRS website and they must be submitted by the January 31st deadline.
The vast majority of businesses hire traditional employees, also known as W-2 employees. In this relationship, the employer provides the employee all the necessary tools, equipment, and supplies to do the job. Typically, the employee is required to work set hours and days as determined by the company. The relationship is intended to be permanent or semi-permanent, not temporary.
The IRS looks at 3 categories to determine the degree of control or independence in your relationship with your worker:
- Behavioral - Do you control (or have the right to control) what the worker does and how they do their job
- Financial - Are the business aspects of the workers job controlled by the payer (these include things like how the worker is paid, whether expenses are reimbursed, who provides supplies)?
- Type of Relationship - Are there written contracts or employee type benefits (insurance, vacation)? Is the relationship permanent? Is the work that is performed a key aspect to the business?
A little bit about Misclassification fines through the IRS:
- Make sure you define employee or independent contractor correctly based on the information I gave you. It can have costly financial penalties and no one wants unexpected costs.
- If you misclassify, you are not paying unemployment or any other taxes on your workers when you really should be, and they are not covered with workers compensation and unemployment insurance when you are required to pay that for employees.
- If you are found to have misclassified, you will likely have to repay all of those taxes and benefits that you weren’t paying before.
Common financial penalties:
- Reimbursement for wages like overtime and minimum wage
- Back taxes and penalties for federal and state income taxes, Social Security, Medicare, unemployment insurance
- Providing health insurance, retirement, etc.