Independent Contractor or Employee? Why the Difference Matters at Tax Time

If you own a business, there’s a good chance you’ve hired someone as an independent contractor at some point. It’s common, it’s convenient, and for the right situation it makes perfect sense. But one mistake we see business owners make is assuming that simply paying someone as a contractor automatically makes them one.

Unfortunately, that’s not how the IRS looks at it.

Whether someone is an employee or an independent contractor depends largely on the actual working relationship. The IRS looks at things like how much control you have over the person’s work, how they are paid, who provides the tools and equipment, whether they have an opportunity for profit or loss, and the overall nature of their relationship with your business.

For example, let’s say you hire someone to redesign your office. They have their own business, bring their own tools, determine how the work gets done, give you a price for the project and work for several other customers. That sounds much more like a traditional independent contractor.

Now imagine you have someone who works for you every Monday through Friday, you determine their hours, provide the equipment they use, train them on how you want the work performed and oversee their day-to-day responsibilities. Calling that person a contractor and giving them a 1099 doesn’t necessarily make them an independent contractor.

That distinction matters because the tax treatment is very different.

When you have an employee, you generally have payroll responsibilities. Federal income taxes are withheld from their pay, along with their portion of Social Security and Medicare taxes. As the employer, you also have your portion of payroll taxes to pay and additional reporting requirements.

With a legitimate independent contractor, you generally don’t withhold those taxes from their payments. The contractor is self-employed and is responsible for reporting the income and paying the applicable income and self-employment taxes themselves. Depending on how much you pay them and the circumstances, you may also be required to issue a Form 1099-NEC.

Where business owners can run into trouble is when someone has been treated as a contractor but should have been classified as an employee.

If that happens, the business could potentially become responsible for employment taxes that should have been withheld or paid. Depending on the situation, there can also be penalties and interest. What seemed like a simpler arrangement at the beginning can turn into a much more expensive problem later.

Another important thing to remember is that there isn’t one magic test that determines whether someone is an employee. Having a contract that says “independent contractor” isn’t enough by itself. Neither is paying someone without withholding taxes or issuing them a 1099.

The actual facts matter.

This can become especially confusing as a business grows. Maybe you originally hired someone for an occasional project, but over time they started working for you every week. Their responsibilities increased, you began setting their schedule, and eventually they became an important part of the daily operation of your business.

At that point, the relationship may look very different than it did when you originally hired them.

That’s why it’s worth reviewing these arrangements periodically instead of waiting until tax season or until you receive a notice questioning the classification.

If you’re hiring your first contractor, adding employees, or you’ve had the same contractors working with your business for years, this is one of those areas where asking the question ahead of time can save you a major headache later.

And if you’re unsure whether someone working for your business should be classified as an employee or independent contractor, TaxPointe can help you look at the situation and understand the tax implications before it becomes a bigger problem.

Sometimes a small tax question today can prevent a very expensive tax problem tomorrow.