Do you know the difference between an employee and an independent contractor? An employer can hire an employee or independent contractor to perform the same job, but these two classifications are very different. Classifying a worker determines how you pay them, what benefits they receive, and how taxes get paid.
The IRS provides three Common Law Rules to help you define your employees from independent contractors:
Behavioral: Can your business control what the worker does and how they do their job?
Financial: Does your business control financial aspects of the worker’s position such as pay, reimbursement, and tools/supplies provided?
Type of Relationship: Do you provide the worker with benefits such as insurance, paid time off, etc.? Is it an ongoing relationship? Does the worker perform a key role in the business?
If you answer yes to all these questions, then you will most likely classify the worker as an employee. However, it’s not always that easy. Let’s take a closer look at some of the different aspects of an employee and independent contractor.
W-2 Employee
An employee is eligible for benefits, receives an hourly wage or salary and the working relationship is on a regular and ongoing basis. Employers generally have a high level of control over employees with the right to determine what and how work will be done.
As an employer, you must abide by the Fair Labor Standards Act (FSLA) which requires minimum wage and overtime pay. You also need to withhold income, payroll, Medicare, and unemployment taxes as well as Social Security on wages paid to an employee. For each employee, it is required that you file a Form W-2.
1099 Independent Contractor
Contractors are self-employed and generally hired to provide a specific service. Terms of their employment are defined by a written contract, which usually details the rate and duration of work. Since they are self-employed, they pay their own employee and self-employment taxes, so you don’t have to. Independent contractors aren’t eligible for benefits such as insurance, paid time off, and overtime.
If you’ve hired a contractor and paid them at least $600 for the year, you will need to file a Form Form 1099-NEC. The deadline to file 1099s and W-2s is January 31 so, if you don’t know whether a worker is an employee or contractor, it’s time to find out!
Classifying a Worker
The table below provides an overview of some of the differences between an employee and an independent contractor. However, you may find some crossover between the two classifications. Some factors may indicate the worker to be an employee while others indicate an independent contractor. It’s important to look at the relationship as a whole to determine how to classify your worker.
Consequences of Misclassifying an Employee
Misclassifying an employee can result in owing taxes and benefits and facing penalties. Since independent contractors aren’t protected by most state and federal employment laws such as minimum wage, overtime, and workers' compensation, some employers may wrongfully classify an employee to save money. If an employer classifies an employee as a contractor, they may be violating labor laws regarding wage, tax, and employment eligibility.
Some consequences an employer may face for misclassifying an employee include:
Paying payroll, unemployment, and Medicare taxes as well as Social Security for each misclassified employee
Interest on unpaid taxes
Fines for employees that don’t have an I-9 on record
$50 for each W-2 not filed
Criminal and civil penalties
Payment to reclassified workers
In some cases, an employer may believe a worker doesn’t qualify as an employee. If you have a reasonable basis for not treating a worker as an employee, then you may qualify for relief under Section 530.
Still don’t know how to classify your worker?
If you’re still unsure about how to classify a worker, you can talk to your bookkeeper, accountant, or HR department. They should be able to give you guidance and help you choose the correct forms to file. For businesses in Washington state, the Employment Security Department provides a test to determine your worker’s status which is based on the Washington State Legislature law RCW 50.04.145. You can also fill out a Form SS-8 and send it to the IRS for them to determine your worker’s status.
We hope that this article helped you understand the difference between employees and independent contractors. If you’re in need of a bookkeeper, Summit Bookkeeping is currently taking on new clients. Our team stays up to date on the latest employment and tax laws so that we can help you pay relevant taxes and prepare W-2s and 1099s for your workers. Contact us or give us a call at (360) 756-5020 to see how we can best help you!