| Employee or Independent Contractor? |
One of the great frustrations of being self employed or owning a business is that the tax laws make it costly and time consuming to employ someone on a casual basis.
If someone meets the tax law definition of an employee, the employer is required to
(1) withhold federal and state income and social security taxes
(2) contribute 7.65% of the total wages for social security taxes
(3) pay federal and state unemployment taxes of up to 5% or more
(4) pay for workman's compensation insurance
(5) pay a minimum wage per hour and pay a premium for overtime
(6) avoid any kind of hiring or firing discrimination
(7) spend a lot of time on paperwork to comply with these rules
If a business or self employed person hires an independent contractor (IC), then the only requirement for the employer is to pay the amounts agreed upon. If the IC receives total compensation of $600 or more in a calendar year, the the employer has to file a Form 1099 - Miscellaneous Income. The IC is obligated to report any income received but is permitted to deduct expenses incurred to earn that income.
A lot of people seem to believe that if the amount paid to an IC is less than $600 in a year, then the IC is not required to report that as income or to pay self employment taxes on that income. Sadly, that's a common myth that is not supported by any part of the tax law. An independent contractor is required to pay self employment taxes on any net self employment income for the year of more than $400 and income taxes must be paid on any amount of net income after allowable deductions and tax credits. Net income for this purpose is total income received less expenses paid to earn that income.
From the perspective of the small employer, there is a great incentive and temptation to treat someone as an independent contractor and to let them cope with the related tax obligations of a self employed person. This is particularly true when the person employed is only employed for a short time or to do a specific task.
If someone should be
treated as an employee and the employer does not withhold taxes from
the wages paid, the
representative of the employer who has the authority to not
withhold or to not pay the taxes that should have been withheld and
paid will be personally
liable for those taxes.
How can the employer determine when to treat someone as an employee and when someone can be treated as an independent contractor?
The simple answer is that an independent contractor is self employed and works for the public rather than for one employer. The IC has an office (even if only at home), usually has his own equipment to do his work, usually sets his own working hours, usually spends money advertising to get more customers, almost always submits an invoice to the customer and contracts to do a task based on results rather than on a process. If the task is not completed as agreed upon, the IC is often not paid for the work.
In essence, the IC is in business for himself -- even if part time and even if his office is in his home. The IC may make a profit or incur a loss on any single job or even for any entire year.
An employee has little or no financial risk other than of being fired before some agreed upon period of time. The employee is provided with the tools to do the work and usually works at the office or facility of the employer. The employee typically is required to work during hours set by the employer and is expected to follow a process. If the employee does not accomplish a specific result, the employee will still get paid for the time tha was worked.
Basically, the employee gets paid for his time. The independent contractor gets paid to complete a specific task. Borderline cases require a careful study of the IRS rules (below) to avoid the 100% penalty on the taxes that should have been withheld.
The following Internet links provide further details about the difference between an employee and an independent contractor.
http://www.irs.gov/businesses/small/article/0,,id=99921,00.html
http://jobsearchtech.about.com/od/laborlaws/l/aa121800.htm
http://www.taxprophet.com/apps/active2/
http://www.workerstatus.com/
http://www.turbotax.com/articles/EmployeevsIndependentContractor.html
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