Business growth, especially growth during economically trying times, is a great success and should be celebrated. But new growth can also bring a certain level of stress. To deliver promised products and services to new customers, most leaders will need to hire more workers. This responsibility can feel overwhelming, especially when leaders are unsure how to fill their workforce.
Independent Contractor vs. Employee: What’s the Difference?
A common workforce decision for business owners is whether to hire independent contractors or bring on new employees. Both types of workers can help further the business’s objectives, but the business’ obligations will differ greatly.
Employees are permanent members of the organization. They are afforded certain rights under both federal and state labor laws. The Fair Labor Standards Act (FLSA), for example, establishes minimum wage and overtime pay for employees, while the Occupational Safety and Health Administration (OSHA) provides guidelines to help ensure workplaces are safe. Federal laws like the Affordable Care Act also require many employers to provide healthcare coverage to their employees.
Independent contractors are not afforded these same rights. As the name suggests, independent contractors function independently of the company. The business can direct the results, but it cannot control how the contractor completes the job.
The two categories have different legal and tax consequences. The IRS (and many states’ departments of labor) will be paying close attention to worker classifications come tax time. There is no federal bright-line test for determining when a worker crosses the threshold into being an employee, but in general, the IRS will look to control. They will want to know who has control over the behavior of the worker, how the finances are managed, and the type of relationship the parties have. Answering some of the following questions can help point to a determination.
- How is the worker compensated?
- What factors are written into the contract?
- Does the worker receive any benefits like sick days, a pension, or insurance?
- Has the worker invested a significant amount of time, energy, and equipment in their business?
- Are the worker’s efforts correlated with their endeavor’s success or failure?
- Is the worker seeking other business opportunities by marketing themselves, taking new client calls, etc.?
- What type of training, if any, does the business provide to the worker?
- When and where does the worker perform their job duties, and whose tools or equipment do they use?
Not all states follow the federal government’s lead on determining employment status. California, for example, passed a law in 2019 that more clearly defines the activities that push a worker into that employee classification. Their ABC test was controversial when it was released because it implied that independent contractors who perform activities that are central to the business’s operations will be considered employees. In recent months, the state has been enforcing their stance in high-profile cases involving businesses that make a living using the labor of independent contractors, including some big-name players like Uber and Lyft.
In general, businesses will have more tax filing requirements with employees than with independent contractors. With employees, the business must:
- Withhold income and payroll taxes on behalf of their employees
- Pay Social Security tax (6.2% of gross wages) and Medicare tax (1.45% of gross wages) to cover their portion of Federal Insurance Contributions Act (FICA) taxes
- Pay unemployment insurance on behalf of their employees
- Pay for worker’s compensation coverage
- File payroll tax returns and generate W-2 forms for all employees
Businesses do not have to perform any of these tasks for independent contractors. Because independent contractors are self-employed, they pay both the employee’s and the employer’s portion of FICA taxes from their own earnings. Businesses will not be expected to pay overtime, adhere to minimum wage expectations, pay for the worker’s retirement or sick leave, or offer the worker any sort of company-wide fringe benefit. Businesses will be expected to file Form 1099 for each independent contractor they pay more than $600 per year, but they will generally not need to file any other tax forms.
If a business incorrectly classifies their workers as independent contractors, there may be steep consequences. For example, if their state or the U.S. Department of Labor discovers the mistake, the business will be liable for paying back payroll taxes for the worker and will likely be assessed penalties and interest for both non-filing and late payment of these taxes. Back pay may be required as hours worked or overtime may not have been calculated correctly. There may even be late retirement contributions, among other consequences, if the formerly misclassified employee would have been eligible for such.
If business leaders are unsure how to classify their workers, they can file Form SS-8 with the IRS. The IRS will review the facts and circumstances of the business relationship and will make a binding determination on the worker’s employment status.
If you have further questions about the employment status of your workers, contact our CRI CPAs today. We can walk you through these questions and figure out if a formal determination from the IRS is warranted.