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Independent Contractor vs. Employee: What Can These Workers Offer Your Business?

Payroll
Article
08/13/2018

Entering a new worker into a payroll system can be a confusing process, especially when it comes to determining the difference between an independent contractor and an employee. Some employers want to determine if a worker is a good fit for their company before undertaking new-hire paperwork, while others may think a new part-time employee can be paid in cash and treated as an independent contractor.

But it's important to understand the differences and benefits of independent contractor vs. employee, both in terms of what they offer the business but also when it comes to compliance with regulations.

Tax requirements

An employee is generally considered an individual who works for wages and salary, while a freelance or independent worker signs a contract to provide specified services at an agreed-upon price and time and during a specific time frame. It may seem as though the categories occasionally overlap, but non-compliance with IRS rules in this area can lead to stiff financial penalties for an employer.

The level of control an employer has over a worker generally determines whether a worker should be considered an employee or contractor for tax purposes. Here are commonly accepted indicators of control:

  • Behavioral: Does the employer control how and when the worker does their job?
  • Financial: Does the employer control when and how the employee is paid and which expenses, if any, are reimbursed by the employer?
  • Relationship type: Does the worker have a written contract or receive any type of benefits such as sick leave, paid vacation days, or health insurance? Is the relationship ongoing or finite in length?

Based on this determination, here are tax forms employers should know:

For independent contractors

Business owners should request that independent contractors complete a Form W-9. This form requires a contractor's taxpayer identification number, which is a Social Security number or an employer identification number. This form should be on file for four years in the event any questions arise from either the contractor or the IRS.

IRS Form 1099-MISC is used by businesses to report the total compensation paid to an independent contractor in the previous tax year. This form is filed with the IRS and provided to the contractor for reporting income. Contractors who were compensated $600 or more for services rendered during the tax year are required to be issued a Form 1099-MISC. Businesses must file the Form 1099-MISC with the IRS by February 28 (March 31, if filed electronically). They are also responsible for providing independent contractors with a copy of Form 1099-MISC by January 31 of the year following payment.

Businesses should also file Form 1096, which includes the combined totals for all independent contractors paid $600 or more during the previous tax year. Employers should not withhold any taxes from a contractor's wages. Contractors pay taxes directly to the federal government and employers don't have to match any of their Social Security or Medicare taxes, as they do with employees. No unemployment tax is owed for those workers.

For employees

Every business has an employer identification number used by the government to help track an employer's tax payments.

For each person hired, the employee fills out a Form I-9, verifying the individual's eligibility to work in the United States. An employer must also collect every employee's Social Security number to enter on an annual Form W-2 wage and tax statement, as well as a signed Form W-4 that provides the information needed to calculate the amount of federal income tax to be withheld from each paycheck.

Certain forms need to go to the IRS and the Social Security Administration, such as the quarterly federal tax return for employers (Form 941) or the annual Federal Unemployment (FUTA) Tax Return (Form 940).

Making the decision to hire: independent contractor vs. employee 

Consider hiring a full-time employee if the job entails ongoing supervision, control of the time and resources used by the employee, and if the work is indispensable to a business. An independent contractor might be more desirable if the job is peripheral to your business, can be completed by an expert who doesn't need supervision, and/or entails a short-term time frame.

With an increasingly competitive labor market, contract and freelance workers now differentiate themselves by becoming proficient in highly specific niche markets. As advancements become more broadly adopted within an industry, they will require industry specialization to apply them effectively. Employers working to keep pace with sophisticated technologies may see a significant advantage in drawing on the specialized expertise and experience of independent contractors.

At the same time, employers should be on the lookout for independent contractors who want to return to full-time employee status. By its very nature, freelancing means embracing a state of flux. A major life change or circumstance, such as having a child, may prompt the desire for the stability and benefits that come with full-time employment. Other freelancers simply may become tired of the hustle, or weary of worrying about money.

Matching the right resource with your wants and needs

Knowing which resources to call upon at a given time can help you determine whether a contractor or full-time employee is best suited for the business’s needs.

For example, if you face an impending deadline on a major project, it might be wise to bring on a contractor who can focus on the job at hand and meet deadlines. This can be preferable to demanding that one or more full-time employees put in extra hours on the project.

A skilled contractor might also be a solution if your project includes a highly specialized skill. From computer programming to graphic design, contractors may get a job done quicker than an in-house employee whose main duties lie elsewhere, and who must be specially trained to meet a project demand.

On the other hand, if your company requires a specific type of skill as part of its ongoing business, hiring a full-time employee probably makes more sense. Having this in-house resource ready to meet a consistent demand may be a better option than searching for a contractor at the last minute.

Service-based businesses are often best served with a full-time staff, because these individuals offer the valuable element of business continuity. Repeat customers know who they're dealing with and can expect that an employee familiar with their needs will serve them in an efficient, knowledgeable manner.

Who to hire?

The following checklist offers other considerations affecting a business owner's decision to hire a contractor or an employee:

With a full-time employee, an employer:

  • Has total control and direction over that person's work activities;
  • Can train the individual any way they desire;
  • Can require the employee work only for them; and
  • Can terminate that employee at any time.

With an independent contractor, a business owner:

  • Assigns specific projects and/or responsibilities;
  • Establishes a deadline for project completion and delivery of services; and
  • Has limited reporting or tax obligations.

Take time to assess the pros and cons of each type of worker; both offer certain advantages, challenges, and other considerations.

This website contains articles posted for informational and educational value. Paychex is not responsible for information contained within any of these materials. Any opinions expressed within materials are not necessarily the opinion of, or supported by, Paychex. The information in these materials should not be considered legal or accounting advice, and it should not substitute for legal, accounting, and other professional advice where the facts and circumstances warrant.
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