Many businesses will reach a point at which they need to hire help. At this time, they must decide whether to hire employees versus independent contractors. The difference between these classifications has important legal and tax implications. Understanding the differences can help you determine which works best for your situation.
Under common law rules, employees are individuals who work under the control of a business in a formal agreement. Even if the worker has some level of freedom (for example, a worker with enough experience to perform their job duties without assistance or supervision), he or she may still be an employee if the employer can control details of how their services are performed, including when, where, and how the work is performed. The facts and circumstances determine “employee” classification no matter how parties decide to label it. For this reason, it is important to correctly classify an employee from the beginning of the relationship so that the employer does not fail to meet its responsibilities.
Employers must withhold and remit income taxes, Social Security taxes, and Medicare taxes from employee’s pay. Further, they must withhold certain payroll taxes. Employers must also comply with federal and state labor laws, including minimum wage, overtime, and anti-discrimination regulations. Employers may be required to provide certain benefits to employees. Benefits include health insurance, retirement plan participation, workers’ compensation, unemployment compensation, and paid time off. Being an employer requires administrative time to understand and comply with these requirements. Moreover, employers generally must register with their state and file payroll tax returns on an ongoing basis. Employees are issued Form W-2 by their employer at year end detailing their income and tax withholdings.
Independent contractors are self-employed individuals who offer their services to other parties. They control the details of their work, such as when, where, and how their services are performed. They are responsible for handling their own taxes and typically do not receive any benefits from the contracting entity. However, they do not receive protections provided by employment laws. The contracting entity may need to issue Form 1099 to an independent contractor at year-end, but little additional administration is required for this relationship. Because of the flexibility of this relationship, there is generally no state or local registration necessary to hire an independent contractor.
Utilizing an independent contractor can provide a business with time and cost savings over hiring an employee. It can also offer greater flexibility for businesses to utilize an independent contractor’s services as needed. Because of this, federal and state agencies such as the IRS and the Department of Labor are increasingly focused on identifying when companies are misrepresenting employees as independent contractors to circumvent tax and labor laws.
Choosing the Right Classification
When deciding which type of worker is best for your business, here are some factors to weigh:
- Control of work product: Consider whether your business needs specific services that it would like to oversee and control. If this is the case, an employee may be a better fit. Or, if you prefer a more hands-off approach where another party provides their expertise without significant supervision, an independent contractor may better meet your needs.
- Flexibility: Is your business looking for a stable and long-term source of labor or a shorter-term flexible arrangement on an as-needed basis? Employees will generally provide more stability, and independent contractors will have greater flexibility.
- Time and cost: Hiring employees requires greater administration and increased costs to provide benefits, office space, payroll taxes, and to meet all legal requirements of employment. Independent contractors save time and money on these fronts, but the contractor may charge more per hour than an equivalent-level employee.
The Bottom Line
It’s essential to weigh the advantages, disadvantages, and legal implications of hiring employees versus independent contractors. By doing so, business owners can ensure compliance with regulations while also meeting the specific needs of their operations. Classifying workers involves legal complexities that vary by state. More and more, worker classification audits are taking place. Therefore, businesses should perform internal reviews on a regular basis to determine whether the evolving nature of a person’s work has changed their classification.
If you’re uncertain about how to classify workers or need assistance with payroll and tax compliance, consulting with a professional can provide invaluable guidance. Our experts at My CPA are ready to help. Contact us today to learn more.