The businesses’ need to cut back on costs and achieve higher operating efficiency has made the idea of hiring independent contractors more lucrative with every passing day. While most professional finish the task, get paid and never think about it until the tax time is around the corner, there are businesses who misclassify their workers erroneously due to the complex nature of tax laws or deliberately to save on additional employment costs. Such misclassification can have a deep and negative impact on your business, both financial as well as reputational.

Through this write-up we intend to enlighten you about the difference between a W-2 employee and a 1099-contractor in to avoid the needless chagrin from coming up on the IRS’s radar. We will also discuss about the pros and cons of being an employee and a contractor, from the point of view of both an individual and a business. Lastly, we will take a look at the decisive factors for being an individual contractor.

Difference between Contract Employees and W-2 Employees

In order to be able to distinguish the people working for you into the two categories, it is necessary that you understand the difference between the W-2 employee and an independent contractor. Let us take a look at the important characteristics of an employee and a contractor that will help you tell them apart.

  • Withholding the Taxes

This is one of the major differences between the W-2 income and self-employed income. When you are hiring an employee, you shall withhold their taxes by deducting a portion from their paycheck. In simpler words, you will pay their taxes on their behalf. You will issue your employees a W-2 form at the end of the year. It mentions their income and the amount withheld for the purpose of paying off the federal and state taxes. You will need to submit a copy of it to the IRS as well.

On the other hand if you are hiring an independent contractor, you are not supposed to withhold their taxes. Since the independent contractors do not have an employer, the responsibility of computing and paying their own taxes falls upon them. As a client you shall provide them with a 1099-MISC form and shall submit a copy of the same to the IRS, to report the amount you have paid them for their services.

  • Control in the Watchword

If you exercise strict control over the methods of working and number of working hours of your workers, and if they are expected to follow the workplace protocols and the code of conduct, they certainly are your employees. An independent contractor is just concerned with completing the assignment according to the guidelines within the agreed time limit and getting compensated for the same. The company they work for does not monitor their working hours or how they get the task done. Independent contractors are their own boss.

  • Number of People You Work For

It is quite obvious that an employee can work only for one employer. Independent contractors can take up multiple assignments and provide their services to multiple clients, simultaneously.

  • Place of Work

Employees need to work from employer’s premises aka the office. Independent contractors may or may not need to work from their client’s premises, depending upon the nature of work. For example, an independent interior decorator will need to be working at their client’s premises in order to give it a face-lift. On the contrary, an independent medical biller/medical coder can do their job remotely from the comfort of their home via the internet. Moreover as opposed to employees, independent contractor have their own set of tools and resources that they put in for completing their jobs.

  • Training

Employers make sure that their employees remain at the top of their game at all times. Hence they provide training to their employees, so that it works in their best interest. Such scenarios do not usually occur in case of independent contractors. They are not provided any training by their clients. They are specialists and self-taught workers. If at all they need training, they seek it from other sources, such as a crash course or coaching class. However, employees always get their training from the employers when they need to develop new skills as the newer, more challenging projects come in.

  • Entitlement to Benefits

Usually it is said that the best part about being an employee is that you are entitled to the benefits offered under the course of employment; such as 401k, paid sick leaves, health insurance, etc. Individual contractors are certainly not entitled to any of the aforesaid benefits. Their clients may just reward them in the form of bonus for their exceptional services at their own discretion.

Example

Suppose you are a teacher at the elementary school in your neighborhood. You teach the class according to the plan laid down by the authorities and try to finish off the program of study within the stipulated time period. You are also needed to be present in the school for the particular number of hours every day. You utilize the resources and the study material provided by the school to teach the students. The school pays you the salary after deducting the taxes. That clearly makes you an employee of the said elementary school. This is the black area.

Now consider another scenario where you conduct classes in the evening at your place, where you tutor the students. You work as a tutor not because it is your hobby or out of the goodness of your heart, but to earn an income. You arrange to conduct the classes at the time of your choice. You pick the subjects and frame the program of study according to what you deem fit. You have invested in the resources and study material to help the students learn. In this case, you clearly are an independent contractor and receive payment for your services from your multiple clients, i.e., your students. Let’s say this is the white area.

Let us consider the third scenario where the school has hired you for tutoring the students at your place. They have provided you with the guidelines pertaining to the subjects and contents of the syllabus. They decide upon the time of conducting the classes at your place. You use the resources provided by the school to help the kids learn. You are being paid by the school and not directly by the students. This is a grey area. After thoughtful consideration of all the aspects you can safely conclude that you are an employee in this case. This is mainly because of the high degree of control being exercised over you by the school.

W-2 Employee or Independent Contractor – What is your Best Bet?

Hiring employees or independent contractors both have their own pros and cons. You will need to consider the big picture in order to find out which option makes greater financial sense. As mentioned before, employees are entitled to benefits and incentives offered by their employers, thanks to the pension and benefit laws and non-discrimination laws. So as an employer, you will need to shell out the funds to fulfill the legal obligations towards your employees. Take a look at the numbers to get an idea how much difference would it make in financial terms if you were to hire a person as an employee instead of an independent contractor.

–        The rate of Social Security tax that is collected in the form of payroll tax is 15.3 percent, on the income of the employee up to $113,700. You are required to pay the one-half of your employee’s Social Security tax, i.e., 7.65 percent and the other half shall be deducted from their salary.

–        In addition, you are required to pay the one-half of the 2.9 percent, i.e., 1.45 percent of the income of your employee towards the Medicare tax. The remaining 1.45 percent shall be withheld from their paycheck. There exists no criterion of minimum income for the Medicare tax rate to be applicable.

–        However, if the income of your employee exceeds $200,000, an additional Medicare tax at the rate of 0.9 percent shall be charged, which needs to be entirely borne by the employee. So the additional 0.9 percent is really not your concern.

If you hire a person as an independent contractor, you will save on the incentives and benefits to which only the employees are exclusively entitled. You also save on the 7.65 percent of the Social Security and 1.45 percent of the Medicare tax that you would pay, had you hired the person as your employee. You simply remunerate the independent contractor for their services, without withholding any deductions.

Therefore, it makes more sense hiring independent contractors. But you must consider its spin-offs as well. It all depends upon the nature of your business, whether or not hiring contractors is a suitable affair. Nevertheless, as long as you follow the rules and do not misclassify the people who work for you, you should be fine.

We have considered the business owner’s view point; now let us take into account the individual’s viewpoint. As an individual worker, you might feel that working as an independent contractor is the better choice, since you get to work according to your “manner and means”. There is s higher degree of flexibility and lesser supervision and control. You get to decide how, when and where to invest your funds to make your business grow. There are numerous business expenses that you can deduct from the taxable income and save yourself from large tax-bites. There is greater flexibility when it comes to paying your taxes. Not to mention the broad selection of pension plans you get to choose from.

However, the amount of tax that you will own to the IRS will be greater. Since you do not have an employer, you do not have anyone to pay the one-half of your taxes.  Your income up to $113,700 is subject to 15.3 percent tax, beyond which the tax rate plummets to 2.9 percent. While your paycheck may look bigger, a larger proportion of it would go into paying the taxes. To top it all, you also need to pay the self-employment tax.

Criteria for being able to Work as an Independent Contractor

If you wish to work as an independent contractor and be recognized as the same in the eyes of the IRS, it is vital that you meet the criteria, which has 3 aspects; the behavioral control, financial control and type of relationship between the parties.

  • Behavioral Control

The aspect of behavioral control illustrates who directs and controls the manner and means of your work and to what extent. Normally, the employees receive thorough and precise instructions on how they are supposed to proceed and complete the task assigned to them. The instructions could pertain to the following.

–              How, where and when the assigned task needs to be completed

–              What means and resources/tools be used to complete the assigned task

–              Who could assist you in completing the task and hiring them for you, again, as an employer or a contractor

–              Where to procure the supplies and services from

If you receive instructions that sound more like a rough guideline as to what the assignment needs to be like upon completion or just when it needs to be completed, it is more like working as a contractor. In such cases you are free to choose the “manner and means” of your work. Hence, the degree of control matters a lot if you wish to work as a contractor.

  • Financial Control

The aspect of financial control deals with the degree of autonomy or direct control that you have over the finances of the business. An individual contractor works from his own office/home office and utilizes his own resources, they have made a major investment in their work. However, this is not the litmus test of being a contractor. The contractor does not necessarily need to have a significant investment in their work.

Most expenses incurred by the contractors in the course of their work are often not reimbursed by their clients; they are borne by the contractors themselves. If at all some expenses are reimbursed, the proportion of non-reimbursed expenses stays higher.

If the profit earned or loss incurred by our business directly affects your financial well-being, then you are certainly an independent contractor who is in business for himself.

  • Type of Relationship between the Parties

This facet points out the facts that indicate the type of the relationship between the parties, which could be an employer-employee relationship or contractor-client relationship.

–              The fact that you receive benefits such as 401k, health insurance, paid sick leave, etc point towards the existence of employee-employer relationship. The lack of any such benefits means you are an independent contractor who receives nothing more than a deduction-free paycheck.

–              A written contract that could point out the intention of both the parties could serve as a fact to determine whether or not you are working as an individual contractor.

 

  • Proving your ‘Self-Employed’ Status

While you may call it being a freelancer, 1099-ner or sole proprietor, the IRS for the purpose of assessment calls it ‘independent contractor’. Proving that you are a self-employed individual is the real litmus test of being an independent contractor.

Thus both being ‘self-employed’ and running a business and not doing something as a hobby or out of the goodness of heart are the two most important criteria that help you qualify as an independent contractor.

It today’s competitive era of corporate warfare, it is crucial that you do not make mistakes that will make you lose the edge over your competition. Misclassifying your workers is one such area. The IRS has been taking strict action against the businesses that misclassify their employees to save on the cost of employment. If you feel you have erroneously misclassified your employees as contractors or vice-versa and in order for the IRS to assist you in establishing the actual status of your workers, you can file Form SS-8. Misclassification of workers costs IRS millions of dollars in taxes that went uncollected and by doing so you are running a risk of getting penalized by the way of imposing hefty fines and interests.