Employee vs. Independent Contractor — What’s the Tax Distinction?
The distinction between employees and independent contractors is important when it comes to taxes, as it determines how the person is paid by their employer and where their taxes are allocated. However before we dig into the tax distinction, it’s important to define what it means to be an employee vs. an independent contractor.
An employee refers to an individual who works for an employer that controls the work of the employee. This includes everything from what will be done to how it’s done.
An independent contractor is a professional or worker who falls within a trade or business, and offers their services to the general public. These people are considered self-employed, and their earnings are subject to self-employment tax (Social Security and Medicare).
For example, a computer programmer hired on full time with benefits at a tech company would be considered an employee. Someone who operates out of their own home or office as a social media freelancer and provides their services to multiple clients is probably considered a contractor. Keep in mind that determining whether an individual is your employee or a contractor can be complex; if you have questions you should discuss the situation with a CPA.
Why is the tax distinction important?
The reason the distinction is so important is because it determines whether payroll taxes (which are income and FICA taxes) are withheld from a paycheck. A business owner has to withhold payroll taxes from an employee’s wages, but not from funds paid to a contractor.
How does the IRS determine where you fall?
Although this seems pretty cut and dry, it’s certainly not. There are many cases where the waters are muddied when determining if someone is an employee or independent contractor. To help determine where you fall, the IRS has created three basic criteria, or guidelines:
- Behavioral Control. If the employer controls where the employee works, their hours, equipment used, etc. they are considered an employee. If the person creates their own schedule and works with little training or direction, they are considered an independent contractor.
- Financial Control. This includes how someone is paid, whether they’re allowed to work for others, and if they could receive a profit or loss. For example, someone who works full time for one employer and has signed a non-compete is considered an employee, because they’re restricted from working elsewhere simultaneously.
- Type of Relationship. If the individual is entitled to benefits, this signifies an employee type relationship with an employer.
If you’re unsure and want further clarification, you can file a Form SS-8 as a request for determination regarding an individual’s status of employee or contractor.
To complicate things even further, there’s actually an option to categorize yourself as a statutory employee, or “non-employee.” This is essentially a cross between an employee and independent contractor, meaning they are treated as a worker outside the company, but treated as an employee for employment tax purposes (and like an independent contractor for income tax purposes). There are only four categories of people who can claim themselves as a statutory employee, which you can learn more about here.
So how do employees and independent contractors pay taxes?
Employees are paid in a variety of ways, including salary, hourly, commission, or a combination. They are taxed based on their income, and a W-2 form will show you must also withhold federal and state income taxes and FICA taxes.
Working with an independent contractor means you don’t withhold federal or state income taxesor and FICA taxes unless they are subject to backup withholding.
We hope this has cleared up any questions and concerns you may have in filing taxes! If you’re in need of tax filing help, Taurus CPA Solution is here for you. Visit our services page for more info or contact us online today.