Contractor or Employee? Understanding Hiring and Tax Responsibilities

Expanding a business often means bringing additional people into the organization. One of the first decisions a business owner may face is whether a worker should be hired as an employee or engaged as an independent contractor.

The distinction matters for more than payroll administration. Worker classification can affect federal tax withholding, Social Security and Medicare taxes, unemployment taxes, reporting requirements, and the responsibilities assigned to the worker and the business.

Employee vs. Independent Contractor: What Should You Consider?

Before deciding how to classify a worker, consider how the working relationship will actually operate. The following questions can help identify characteristics commonly associated with an employee relationship:

• Is the worker expected to remain with the business for an indefinite period?
• Will the business determine when, where, or how the person performs the work?
• Will the worker follow a schedule established by the business?
• Is the worker expected to regularly work at the company's location?
• Will the business provide equipment, materials, or supplies?
• Is the worker restricted from providing similar services to other businesses?
• Will the person's regular duties be an important part of the company's core operations?
• Will the business provide training or detailed instructions?
• Does the business have an interest in controlling the process used to perform the work, rather than simply receiving the finished result?
• Will the worker receive a predetermined amount on a regular payroll schedule?
• Can either party end the relationship under employment-type terms?

The more these factors describe the actual relationship, the more important it becomes to evaluate whether employee classification is appropriate. Conversely, a worker who operates independently, controls how the work is performed, and is primarily responsible for delivering an agreed-upon result may have characteristics of an independent contractor.

How the IRS Looks at Worker Classification

The IRS generally examines the substance of the relationship rather than relying solely on the label used in a contract.

Three broad categories are particularly important:

1. Behavioral control

This considers whether the business has the right to direct or control how the worker performs the job. Instructions concerning procedures, schedules, methods, or training can be relevant.

2. Financial control

Financial considerations include how the worker is paid, who provides equipment and supplies, whether the worker has unreimbursed business expenses, and whether the worker has an opportunity for profit or loss.

3. Relationship between the parties

The overall relationship can also provide evidence. Factors may include written agreements, employee-type benefits, the expected permanence of the arrangement, and whether the services are an important aspect of the business.

No single factor necessarily determines the classification. The complete relationship should be considered.

What Changes When You Hire an Employee?

When a worker is classified as an employee, the business generally takes on payroll and employment-tax responsibilities.

Depending on the circumstances, these responsibilities can include withholding federal income tax and the employee's share of Social Security and Medicare taxes from wages. The employer may also be responsible for its share of Social Security and Medicare taxes, federal unemployment tax, and applicable state unemployment taxes.

Employee-related expenses can extend beyond payroll taxes. Depending on the business and applicable laws, employers may also have obligations involving:

• Employee benefits
• Workers' compensation
• Overtime and other wage requirements
• State and local employment taxes
• Payroll recordkeeping and reporting

Employees generally receive Form W-2, Wage and Tax Statement, reporting their wages and applicable taxes for the year. Employers must prepare the required forms and provide copies according to the applicable filing and furnishing deadlines.