Contractor or Employee – That is the Question.

As a small business owner, there are many challenges to understanding all of the tax codes regarding payroll taxes and how to treat different workers in your company. Finding the right answer to the contractor versus employee question can mean a big difference in how you treat that individual for tax purposes.

Let’s look at the semantics of each type of worker to better understand how it can impact your small business.

Independent Contractor
Doctors, lawyers, dentists, veterinarians, contractors, writers, graphic designers, and accountants are among just a few of the many professionals who often work as independent contractors. That doesn’t mean that in every instance these individuals can always be considered “independent”. Much depends on how, where, and under what supervision they perform their tasks.

For instance, a physician can work in the employment of a hospital or physician practice and be an employee that receives benefits and pays federal taxes out of each paycheck, while another physician colleague may work per Diem on a contract basis. The general rule from the IRS to determine if the individual is an independent contractor involves whether or not the payor has the right to control or direct only the result of the work and not what will be done and how or when it will be completed. Those receiving pay as an independent contractor are subject to Self-Employment Tax. Remember that for 2010, if you are considered self-employed you can also reduce your net self-employment tax by deducting your health insurance costs on Form 1040.

If you control specific details of your worker’s job such as what will be done and how it will be completed, then you are going to be considered an employer/employee relationship by the IRS. That means that as the business owner, you will be responsible for withholding and paying Federal Income Tax, Social Security and Medicare taxes on behalf of that worker. The IRS takes payroll taxes very seriously. Not only are you paying taxes as the business owner, you are also a third party payor collecting and submitting taxes on behalf of your employees.

Additionally, employers are responsible for paying Federal Unemployment (FUTA) and State Unemployment (SUTA) taxes. FUTA and SUTA taxes are not paid by employees or withheld from their pay. Failure to pay these taxes will result in heavy penalties and fines which can quickly snowball into substantial amounts if you aren’t meticulous in your reporting.

Effective January 1, 2011, taxpayers must deposit all depository taxes such as employment, tax, excise tax and corporate income tax, electronically using the Electronic Federal Tax Payment System (EFTPS). Each state has separate recording and payment systems so it’s important to check with your local and state revenue offices for details. And that’s just the beginning. Managing payroll tasks can be time consuming and confusing for many small business owners. Depending on the size of your staff and to alleviate worry and the risk of over or underpayment, it may be wise to invest in a payroll service to help manage your payroll and all of the changes that seem to come with the job.

To make a determination about how your business should treat an individual who performs work for your company, consider the following test from the IRS:

1) Does your business control or have the right to control what the worker does and how the worker does his or her job? If you control when, where or how the individual performs the work, then the worker is an employee.

2) Are the business aspects of the worker’s job controlled by the payer? For example, do you provide the tools, computer system or other means necessary for the individual to complete their work? If the employee works in your office, uses your computer systems or other tools to complete the tasks, then the IRS would consider that individual an employee.

3) Do you have written contracts or employee benefits for this individual? Does the employee receive vacation pay, retirement benefits, health insurance or other ‘benefits’ of working at your organization? If you answered ‘yes’ then the IRS would consider that individual an employee.

Once you answer these questions, review the results and see to what degree the responses fall in either the independent contractor or employee category. Not only are employers responsible for federal taxes and rules, but each state has its own rules pertaining to independent contractors and employees as well as payroll tax requirements. When in doubt, it is always best to consult a small business accountant or bookkeeper or a tax professional.

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