What is the Difference Between an Employee and an Independent Contractor?
When first starting a business, it’s common to hire staff as independent contractors. However, treating a full-time staff member as an independent contractor means operating by a specific set of rules—and it’s all too common for early-stage businesses to make this mistake. There are several categorizations, and employee versus independent contractor is one of the most vital to understand for a business owner. Let’s talk about the key differences between an employee and an independent contractor, what legal ramifications exist when you’ve misclassified them, and critical measures to properly classify your team.
Independent contractors are hired to perform specific services for a business. They control how and where the work is done, while the business owner controls how the work is implemented. Independent contractors can work for multiple businesses, can have their own employees, and will invoice the business owner.
Employees work for one business with a designated time commitment and payment terms. Their duties, time, and place worked are controlled by the business owner. If work is essential to your business and you need them long-term, the person is probably an employee. The distinction is usually obvious, but if not there are common law principles to help you determine your contractor or employee’s status.
Independent contractors are self-employed, so business owners do not withhold or pay taxes for them. With employees, business owners do withhold income taxes, and also pay Social Security, Medicare, and unemployment taxes. The IRS has more information on when and how you should pay taxes on employees or contractors.
Misclassification of Employees and Independent Contractors
People misclassify workers all the time. Sometimes by accident, sometimes to save money. Employers avoid Social Security and Medicare taxes, overtime pay, employee benefits, unemployment tax, and workers’ compensation insurance if they list a worker as an independent contractor. While it may be tempting to save money, the consequences are serious. If you misclassified unintentionally, you could have to pay:
- $50 for each W-2 you did not file
- Penalties of 1.5% of the wages plus 40% of FICA taxes that were not withheld from the employee
- 100% of the FICA taxes you should have paid, plus interest
- A penalty of 0.5% of unpaid tax liability, up to 25% of total tax liability
If you intentionally misclassified, there can be additional fines, and in some cases criminal penalties up to $1000 and one year in prison.
Think about whether or not the worker fulfills the common law rules for being an employee, and give them the correct tax forms from the beginning. If there’s a disagreement, you can file a Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. Here, the IRS will determine which classification you should use. If you have a contractor you would like to make an employee, simply start a new contract with them as an employee, and have them fill out the proper tax forms. If you’re not ready to make them an employee, you can modify their work terms to ensure they are only a contractor. If you think you could be audited, you can voluntarily pay back taxes to avoid further fines, or apply for Section 530 Relief, which can sometimes relieve you from paying back taxes.
There is a fine line between employees and independent contractors, yet it’s one that has big consequences. Follow the common law principles to make sure you know where your workers lie as far as categorization, and reclassify them as quickly as possible if you find a discrepancy. Contact Anselmo Lindberg Oliver for assistance with your business law questions or to help you if you find yourself in a bind.