You probably remember the first time you considered bringing on another set of hands to help run your small business, maybe it was years ago or maybe you are working through that decision right now.
It is a big milestone and while exciting, also very stressful.
As a CPA, I understand how to help you make those big decisions. There is a process any service-based business can follow to help decide what is best for them and it starts with asking the question – independent contractor or employee?
One of the biggest factors in guiding your decision should be the treatment of taxes for hiring an independent contractor vs. employee.
Freelancers (or independent contractors) are provided many rights employees do not have but it comes at a tax cost. Conversely, employees can reap many benefits but are going to be limited in some ways.
Throughout this article, we will discuss those differences to help you make the right decision.
What is the difference between an Independent Contractor and Employee?
In many areas of accounting, we have straightforward definitions that tell us how to classify certain expenses, assets, or situations. When it comes to independent contractors and employees, there are a lot of gray areas.
The general rule of thumb according to the IRS, is if you can direct the result of the work, but not WHAT or HOW it gets done, the worker is a subcontractor.
To help determine this we look a 3 main criteria areas:
- Behavioral control: type and degree of instruction given, types of evaluation used, and training given. The more instruction / training, the more likely this worker is an employee.
- Financial control: equipment invested by the employee to perform the job, method of payment (flat rate vs. regular wage), unreimbursed expenses. The more financial support you provide, the more likely this worker is an employee.
- Relationship: Are there contracts, benefits, permanency of the relationship, and services provided as a key activity for the business? The more permanent the relationship is with benefits like health care or paid time off, the more likely this worker is an employee.
We have guidelines but many jobs in the ‘gig economy’ today have characteristics that may look like contractor and employee positions. For this reason, many rely on their CPA to help them decide what is best.
Having said that, classifying an employee as a subcontractor with no reasonable basis will make you as a small business owner liable for employment taxes. Certain employers can avoid paying employment taxes if they provide a reasonable basis for not treating their workers as employees. The rules to qualify for exceptions are detailed in this publication: https://www.irs.gov/pub/irs-pdf/p1976.pdf
How do Employees pay taxes?
If you have ever been employed you have likely received a W-2 at the beginning of the year showing earnings from the year prior. That W-2 contains plenty of important information like how much money you earned and paid.
Generally speaking, employees have taxes taken out of their paychecks before they are received. The taxes then go toward their annual income tax payment. This helps ensure people can meet the taxes they are liable for.
Part of those income taxes is also paid by the employer. Making the overall tax payment slightly cheaper for the employee – a benefit of being an employee!
How do Independent Contractors pay taxes?
Employees receive W-2’s and Independent Contractors receive 1099-NECs. This is essentially the same type of document in that it shows what was earned from an employer. However, it is up to the independent contractor to calculate and pay what is owed.
To make the decision even more complicated, not every contractor a business works with requires a 1099-NEC. For example, if the contractor received less than $600 in compensation or was paid via 3rd party (like with a credit card or via a freelance website like Upwork), then a 1099-NEC is not needed.
When a contractor receives a payment from their employer, no taxes are taken out. This means the freelancer will then be responsible for making their entire tax payment. This includes the portion they owe plus the portion the employer would pay if they were an employee.
This can mean higher taxes for the contractor. To help combat this, employers will sometimes offer more compensation to contractors to help cover those costs.
What is better for me, the employer?
Ultimately, the decision is going to be based on your needs and how the points in the above criteria will be met.
A freelancer can generally be cheaper than an employee but that is not always the case and it is certainly not the only factor you should consider.
Something else to consider is The Voluntary Classification Settlement Program (VCSP) allows taxpayers the opportunity to reclassify their workers as employees for partial relief from paying employment taxes in future periods. There are certain eligibility requirements.
Also, for further support, employers can figure out the proper classification using the following:
- Form SS-8 https://www.irs.gov/forms-pubs/about-form-ss-8
- Publication 15-A https://www.irs.gov/forms-pubs/about-publication-15-a
What is better for me, the worker?
Similar to the question proposed above, this is going to be based on your personal situation. You may be in a position where you prefer to be classified as a contractor because of the additional rights provided to you. This may include flexible working hours, more freedom to do your work, or forgoing benefits like health care for higher compensation.
This is true if you are a freelancer or a service-based business.
If you are an employee who thinks they have been improperly classified as a freelancer, you can figure out the amount of uncollected Medicare and Social Security taxes owed using Form 8919 https://www.irs.gov/forms-pubs/about-form-8919.
There is no general straightforward answer in helping determine whether you should hire an employee or contractor. It is going to be the combination of many factors, like the taxes for hiring an independent contractor vs employee, with which your CPA can help your service-based business decide.