CARL WATTS & ASSOCIATES

May 26, 2014

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Contractors vs.
Employees
When you start a business, you almost invariably realize that you need help. Most small business owners start out by hiring outside contractors to do work for them, but at some point they may decide to hire employees as well.

This newsletter’s purpose is to clarify and compare the tax implications of hiring employees vs. independent contractors.

Before you can determine how to treat payments you make for services, you must first know the business relationship that exists between you and the person performing the services.

Under common-law rules, anyone who performs services for you is your employee if you can control what will be done and how it will be done. This is so even when you give the employee freedom of action. What matters is that you have the right to control the details of how the services are performed.

The general rule is that an individual is an independent contractor if you as a payer have the right to control or direct only the result of the work and not what will be done and how it will be done.

In determining whether the person providing service is an employee or an independent contractor, all information that provides evidence of the degree of control and independence must be considered. The facts that provide this evidence fall into three categories: Behavioral Control, Financial Control, and the Relationship of the Parties.

Behavioral Control covers facts that show whether the business has a right to direct and control what work is accomplished and how the work is done, through instructions, training, or other means.

Financial Control covers facts that show whether the business has a right to direct or control the financial and business aspects of the worker's job. This includes:


  • The extent to which the worker has unreimbursed business expenses;
  • The extent of the worker's investment in the facilities or tools used in performing services;

  • The extent to which the worker makes his or her services available to the relevant market;
  • How the business pays the worker, and
  • The extent to which the worker can realize a profit or incur a loss.


Relationship of the Parties covers facts that show the type of relationship the parties had. This includes:

  • Written contracts describing the relationship the parties intended to create;
  • Whether the business provides the worker with employee-type benefits, such as insurance, a pension plan, vacation pay, or sick pay;
  • The permanency of the relationship, and
  • The extent to which services performed by the worker are a key aspect of the regular business of the company.

Take great care when you hire an independent contractor to be sure that you structure the position in such a way that it will withstand IRS scrutiny based on the three guidelines above.

This is important because if you misclassify an employee as an independent contractor (and you have no reasonable basis for doing so), you may be held liable for employment taxes for that worker, and there are huge penalties to pay on back payroll taxes. This can usually happen only if you get picked for an audit or you are reported by a disgruntled contractor who wants to put the blame of unpaid self-employment tax on someone else.


So, getting back to the main purpose of this newsletter, let’s see what your tax obligations are when hiring employees versus independent contractors.

Getting started.

Employers must complete Form I-9 to document verification of the identity and employment authorization of each new employee (both citizen and noncitizen) hired after November 6, 1986, to work in the United States.

Independent contractors receive Form W-9 which is the IRS form used by a company to request a taxpayer identification number. Most often, Form W-9 is sent to independent contractors, consultants, and other self-employed workers. Form W-9 is also used by banks and other financial institutions to request tax information from customers.


Paychecks and benefits.
Employees are normally paid on a set schedule, such as every other Friday, or on the first and fifteenth of each month.

Contractors may also be paid on this set schedule, or their pay periods may differ. You may pay a contractor some money up front and the rest when the job is done, or you may just cut checks to contractors every now and then on request.

When you hire an employee, you get the advantage of being able to completely control and direct that person's work during work time, to train the person in the way you want the job done, and to require that person to work only for you. On the other hand, both the federal government and your state regulate the payment of wages or salaries, overtime, and other work rules. You must comply with payroll tax requirements, including federal income tax and state income tax withholding as well as paying half of the FICA taxes (Social Security and Medicare) for each employee, and collecting the other half from the employee.


As an employee, you also report and pay Federal Unemployment Tax (FUTA) tax separately from Federal Income tax, and social security and Medicare taxes. You pay FUTA tax only from your own funds. Employees do not pay this tax or have it withheld from their pay.

You may also have to pay worker's compensation insurance.

Your withholdings must be deposited and reported according to the IRS and state rules respectively (usually quarterly and annually).

Employees usually receive some benefits which may include health insurance, sick days, paid vacations, stock options and 401k opportunities.

Contractors generally do not receive any benefits in addition to their salary or payment.


End of the year reporting.

After the end of the year, you must provide W-2 forms to your employees by January 31, and then you must submit all W-2 forms, along with a summary report on Form W-3, to the Social Security Administration by February 28.

If you paid someone who is not your employee, such as a subcontractor, attorney or accountant, $600 or more for services provided during the year, you must complete a Form 1099-MISC and a copy of the form must be provided to the independent contractor by January 31 of the year following payment. You must also send a copy of this form to the IRS by February 28 together with Form 1098 to report all payments made to contractors.

Of course, there’s a lot more to be said about pros and cons for hiring contractors vs. employees, but for now you can have an idea of your tax obligations in both cases.

Only you, together with your professional advisors, can decide what better fits your business and your specific circumstances.




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