Have you ever wrestled with the employee vs. contractor question at tax time?
Startup founders are often mindful of their financial resources, and contractors can afford additional flexibility. There are reasons to engage both, and this simple decision can have significant tax implications for your business.
Unfortunately, many run into trouble when they hire contractors but treat them like employees, at least from the IRS’s viewpoint.
In this article, we’ll break down the key differences between employees and contractors and explore the tax effects and considerations of both.
Understanding the Difference Between Employees and Contractors
Before we dive into the tax details, let’s get the basics straight. The table below outlines the fundamental differences between an employee and an independent contractor.
|Business relationship||Works for an employer||Works with one or more clients|
|Schedule||Company-regulated schedule||Sets their hours|
|Tools necessary for work||Receives tools or reimbursements from employer||Has their tools and covers any business expenses|
|Training||Receives employer-provided onboarding and training||Comes with skills and expertise and needs little to no training|
|Taxes||Shares taxes with the employer and has taxes withheld from gross pay||Pays self-employment taxes|
|Tax forms||Files W-2, W-4||Files W-9, W-8, 1099s|
|Compensation||Receives regular, fixed payments, hourly wages, or salary on the company payroll||Receives compensation, depending on payment terms agreed upon in the contractor agreement|
|Employer supervision||Gets direct supervision from a manager||Minimal supervision and controls their own process|
Who is an Employee?
According to the Fair Labor Standards Act (FLSA), an employee is an individual who works under the direct control and supervision of your startup. They typically have a set schedule, work at your designated place of business, and follow your startup’s guidelines and policies.
During that time, you, as the employer, have the authority to oversee and direct their work. Whether they’re working full- or part-time, remotely or in your offices, you specify when, where, and how they do their job.
Employees are often eligible for health insurance, retirement plans, and paid time off benefits. They receive a salary or hourly pay, and you report their income on a W-2. Here’s where many get into trouble. Employers are responsible for withholding taxes from their employee’s paychecks, including income tax, Social Security, and Medicare taxes.
Who is a Contractor?
A contractor or freelancer is an independent worker who offers services to your startup but maintains autonomy. They often work remotely, use their tools, control their schedules and processes, and may have multiple clients.
Contractors have more autonomy than employees, controlling where, when, and how they work. They may also work for multiple clients simultaneously.
Unlike employees, contractors are responsible for paying their income and self-employment taxes. The hiring business makes no withholdings for social security or income tax.
Contractors also don’t receive employee benefits like health insurance, PTO, or retirement plans. They’re running their businesses. Instead of a W-2, you would report contractor income on Form 1099.
Interestingly, the number of contractors has been steadily increasing. A National Bureau of Economic Research paper reports that 15% of workers also work as contractors.
Why Correct Classification Matters
Correctly classifying workers for tax purposes ensures compliance with tax laws, labor regulations, and employment standards. It protects the rights of workers and provides fair competition. Proper classification also avoids costly legal and financial consequences for employers and employees.
Tax Obligations for Hiring Employees
You assume certain tax obligations as an employer. These are crucial to ensuring compliance with tax laws and providing various employee benefits and protections.
Employers should withhold Social Security, Medicare, and FICA taxes from employees’ wages. These withholdings are then reported and remitted to the IRS. The Social Security and Medicare rates can change, making it essential to stay updated each year.
As an employer, you’re also responsible for withholding and remitting federal and state income taxes from your employees’ paychecks to the appropriate tax authorities.
Tax Considerations for Engaging Contractors
Avoiding issues when working with contractors means following a different set of tax considerations than with employees. Laws can also vary from state to state.
Request a completed Form W-9 from each contractor before making payments. This form provides the contractor’s name, address, and taxpayer identification number (TIN) or Social Security Number (SSN), which you will use for reporting purposes.
Any time you pay a contractor $600 or more in a tax year, you must file Form 1099-MISC.
Opportunities for Tax Deductions
Fortunately, working with contractors can reduce your overall tax liability, and your startup can benefit from tax advantages. Businesses can frequently claim the following contractor costs as expenses that minimize tax liability:
- Contract Labor Costs include payments made to contractors through fees, wages, and other compensation.
- Business Expenses such as materials and supplies, equipment, home office expenses, and travel related to their work also count.
- Legal and Professional Fees like attorneys, accountants, or other professionals assisting with contractor-related legal matters, tax planning, or compliance are also generally deductible.
- Contract-Related Insurance Premiums: The cost of insurance policies related to contractor work, such as liability insurance, may be deductible.
But beware, the IRS has strict guidelines on working classification. Misclassifying an employee as an independent contractor can lead to legal and financial consequences. Violating them can result in substantial fines and back taxes, which vary by jurisdiction.
Seeking Professional Guidance when Classifying Employee vs. Contractor
Navigating the complex landscape of employee vs. contractor classification and the associated tax obligations can be overwhelming. Also, tax laws can change, making professional guidance essential.
Tax professionals like the team at Founder’s CPA can ensure you’re complying with applicable tax laws and optimizing your tax planning, especially regarding worker classification.
Whether you need assistance with worker classification, tax planning, or compliance, our team of experts is here to guide you. Don’t wait until tax season arrives; contact us today to ensure your startup is on the right track.