Hire an Independent Contractor or an Employee?

Your business is growing and you need help. Do you hire an employee or an independent contractor?

Difference between an employee and independent contractor

It can be at times difficult to make a clear-cut distinction between an employee and independent contractor. The term independent contractor has been defined by common law, the Fair Labor Standards Act, and court cases. The IRS looks at the degree of control and independence of the worker. The tests for making this determination fall into three categories:

  1. Behavioral: Does the company control or have the right to control how the person does her job?
  2. Financial: How is the worker paid, how are expenses reimbursed, and who provides the the tools, etc?
  3. Type of relationship: Are there written contracts or employee-like benefits? Will the relationship continue, and is the work performed a key aspect of the business?

The IRS has an extensive 20 factor test for determine whether the person is an employee or independent contractor. Basically, if you are directing the person how to do the work, providing significant training, and paying a guaranteed set wage amount, you likely are in an employer-employee relationship.

The pros and cons of employee vs. independent contractor

There are major benefits to having a worker classified as an independent contractor (IC).

  1. Financial. When you hire an employee you will pay a number of expenses that you wouldn’t if you hired an IC, such as employer-provided benefits, office space, and equipment. You must also make contributions on behalf of the employee, including your share of the employee’s Social Security and Medicare taxes (7.65%), state unemployment compensation insurance, and workers’ compensation insurance. These costs could increase your payroll costs by 20 to 30%.
  2. Staffing flexibility. An independent contractor is generally hired for a specific task or project and the relationship ceases at that point. There is no headache of hiring and terminating an employee. In addition, independent contractors are already trained and can be productive on the job almost immediately.
  3. Reduce your exposure to lawsuits. Minimum wage laws, employment discrimination laws, right to form a union, and right to take time off to care for a sick family member or new child are not applicable to ICs as they are to employees

If after applying the above three factors, it is not clear whether the person qualifies as an employee of IC, you may file a Form SS-8 “Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding” with the IRS. The form can be filed by either the employee or the worker and can take up to 6 months for the IRS to make a determination. This can be useful for business owners who repeatedly require the same services.

The downside to hiring an independent contractor is that you do not have as much control over the work that is performed, your right to terminate the IC is not at will, and you may b at greater risk for government audits by the IRS or Department of Labor.

Forms and taxes

If you’ve made the decision to hire an independent contractor, the first step would be to have to worker fill out a Form W-9. This is used to request the correct name and SSN/EIN of the worker. This form should then be kept in your files for future reference if required by the IRS. If you’ve paid the person more than $600 during the year, you must fill out a Form 1099-MISC. The 1099-MISC must be provided to the IC by January 31st of the year following the payment and you must mail a copy to the IRS by February 28th.

If you have hired an employee, there are several forms and taxes for which you are responsible as the employer, including:

  1. Federal income tax withholdings. You should have your employee fill out Form W-4 prior to employment in order to determine the correct amount of taxes that should be withheld from his or her paycheck.
  2. Social Security and Medicare taxes. Employers must withhold part of social security and Medicare taxes from employees’ wages and pay a matching amount. There is also an additional Medicare Tax amount that must be withheld if the employees’ salary exceeds a certain threshold.
  3. Federal Unemployment tax. Employers pay a 100% of this tax. The employee does not pay any portion of this.
  4. State Unemployment tax.

These taxes must be deposited by the employer with the IRS according to two schedules, monthly and semi-weekly. At the beginning of the calendar year you will need to determine the correct schedule to use. The state unemployment tax is deposited with the Texas Workforce Commission.

Conclusion

There some strong advantages to hiring an independent contractor. But employers would be well-advised to understand the importance of classifying their workers correctly. Misclassification can result in having to pay back state and federal taxes for unemployment, disability, social security, and Medicare, as well as expenses, overtime, and retirement benefits.

It is important that you make the correct determination the first time to avoid costly mistakes. The Law Office of Kunal Patel, LLC can guide you through every stage of this process and save you time and money down the road.

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