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Independent Contractor or Employee?

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I find that many small business owners are dealing with the issue of classifying workers as employees or independent contractors. This is particularly true as the internet allows more virtual offices with individuals working from home. There are some obvious cost and liability benefits from using independent contractors—no employment taxes, no employee benefits, and fewer legal employment issues. At first glance, virtual workers seem like ideal independent contractor situations. However, there are more factors to weigh than simply physical location when determining whether a worker is an employee or an independent contractor.

Independent Contractors vs Employees

Regardless of what a professional relationship is called, a business has an employee when certain conditions are met. The IRS provides a general rule that independent contractors work without supervision regarding when and how to accomplish specific assignments. The payer in such situations only controls what results are expected from the work.

The various states also provide guidance on defining an independent contractor arrangement. An independent contractor basically has a large degree of control over how a job is performed, provides the tools and supplies necessary for a job, and does not receive benefits that are traditionally employee entitlements.

A business produces an annual Form 1099 for an independent contractor indicating the total amount paid for the year. The form is sent to the federal government and a copy is received by the independent contractor. An employee receives Form W-2 annually indicating gross compensation and taxes withheld.

Employment Taxes

Federal law requires employers to deduct certain taxes from employee compensation. No taxes are deducted from payments to independent contractors, who are self-employed and responsible for payment of their tax obligations. Payroll deductions from employee pay include federal income tax liability determined from IRS tables on the wages paid. The other deducted federal payroll taxes are the employee portion of Social Security and Medicare contributions under FICA.

Most states and some municipalities require withholding of taxes for their jurisdictions. An employer with workers located in various states is responsible for state taxes and local employment taxes in each locality where employees are present.

Employers are required to remit all withheld taxes. In addition, there are other employment taxes paid from an employer’s own funds, such as matching amounts for FICA. Payment of employment taxes is the responsibility of an employer. This is true even for taxes that should have been withheld from employees but were not. The IRS will assess back taxes plus penalties on compensation paid by businesses that was improperly classified as contract labor. Such payments are deemed disguised wages.

Personal Responsibility

The usual protection of individuals from personal responsibility for obligations of a corporation does not apply to payroll taxes. The IRS may assess a penalty for recovery of unpaid payroll taxes on any person who has authority over the financial decisions of a corporation.

This test for individual liability rests upon control over corporate payment obligations, regardless of a person’s business title. Responsible individuals essentially possess the status to knowingly pay other creditors with funds that are reserved for payroll taxes. The IRS may rely upon the income and assets of any responsible individual to satisfy unpaid payroll taxes. In fact, the IRS may pursue several individuals for the same tax assessment.

For more advice on how to best structure your employee payroll vs. independent contractor status, schedule a free consultation with an expert accountant focused on San Diego’s small businesses.

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This post was written by Profit Wise Accounting