Employee v. Independent Contractor, The Differences and Tax Consequences

Business owners commonly face the decision between hiring full-time employees or independent contractors to do the same work. The financial benefits to a business owner have clouded the distinction between an independent contractor and an employee. Furthermore, the tax consequences for an independent contractor and an employee are substantially different.

Both an employee and an independent contractor are given tax forms at the end of a tax year showing the amounts paid to them. Specifically, an employee is given a W-2 form and an independent contractor is given a 1099 form.

When classified as an employee, the employer deducts payroll taxes from the employee’s wages and also pays payroll taxes for the employee. These amounts are indicated on the W-2. Due to the taxes being paid and withheld throughout the year, employees generally receive a refund when filling their tax returns because too much in taxes was withheld from their wages. This allows the IRS to be paid directly from employers and eliminates a need to collect taxes from individual employees at the end of a tax year.

On the other hand, an independent contractor is paid their wages in full with no deductions taken, placing the burden to pay the taxes on the individual independent contractor. This allows the employer to avoid paying withholding taxes for an employee. Also, an independent contractor is supposed to make quarterly estimated tax payments throughout a tax year. However, it is common for independent contractors to fail to pay the required estimated tax payments, especially when the independent contractors are really employees simply being paid as independent contractors.

The IRS has recently been known to perform payroll audits and to investigate whether independent contractors of a company are in fact full-time employees that should be paid as such. For the IRS and federal tax purposes, the relationship between the worker and the business must be examined to determine the proper classification as an employee or an independent contractor. Typically, the IRS considers all evidence of the degree of control and independence in the relationship.

When thinking of the proper classification between an employee and independent contractor several factors should be considered. For example, an independent contractor would likely have more than one client, while an employee would typically work for one employer. Also, an independent contractor likely sets their own schedule while an employee is assigned their schedule. Additionally, an independent contractor would typically use their own tools and have their own methods for doing work, while an employee would be provided the necessary supplies and likely be trained by a company. Although, the differences between an independent contractor and an employee seem slight and there are financial benefits clouding the distinction, a proper classification is important to comply with the applicable rules of our federal tax system.

Improperly classifying an employee as an independent contractor places a burden on an employee to comply with federal tax requirements that they should not have to comply with. Though, the benefit to the employers of not being required to pay the payroll withholding tax incentivizes employers to classify employees as independent contractors. The IRS will likely continue to engage in payroll tax audits as long as employers attempt to take advantage of the tax benefits of the independent contractor classification.

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