Do you know the difference between an independent contractor and an employee? The status affects how you are taxed.
If you are an employee, your employer must withhold income taxes. They must also withhold and pay Social Security, Medicare taxes, and unemployment taxes on your behalf. As an independent contractor – you are personally responsible for these things.
If you own your own company, it is critical to understand the difference between the two and why one might be better for specific roles you need to fill to avoid financial penalties.
Independent contractors are self-employed. They are contracted for a specific task. They typically set their own hours and often work for multiple businesses at one time. Since they are self-employed, you are not responsible for their taxes or benefits.
At year-end, you are responsible for providing contractors a 1099-MISC (Copy B), and reporting payments made more than $600 per calendar year. You are also responsible for filing the corresponding 1099-MISC (Copy A) with the IRS.
Independent contractors are often paid more per hour because of their expertise in the job you are hiring them for. Since you don’t have to pay for benefits or taxes, contractors are still often more cost-efficient.
To determine if the person you work with qualifies as a contractor, the IRS has 3 questions:
- Behavioral: Do you have the right to control how, when and where a worker does their job?
- Financial: do you control how a worker is paid – reimburse expenses and pay for supplies?
Type of relationship: Is there a written contract or implied permanent status? Do you provide employee-type benefits such as insurance or 401(k)? Is the work that is performed a core business practice?
The IRS looks at the entire package. The law presumes workers are employees unless they meet strict legal requirements that establish someone as an independent contractor.
Employees are hired directly by your business. You set their hours and their duties. You likely provide them a workspace (or permit them to work remotely), and the tools to complete their job.
Your responsibility is to withhold taxes from their paycheck, employment taxes, and any benefits your company offers.
At year end, your business provides them a W-2 form to report wages and the payroll taxes withheld from that compensation. Employers must mail W-2 forms to their employees by January 31 of the following calendar year.
It is important that as a business owner, you fully understand the difference between these two types of workers. A misclassification can cause you financial issues and a big headache.
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