Congratulations! Your team is growing. Now you have moved beyond working alone (or with the free help of family and friends) and into the realm of becoming an employer. One of the first questions that arises is how to know the difference between an employee and a contractor, and I’m here to help you stay on the right side of the IRS definition.
WHY DOES IT MATTER?
In the tax world, the distinction between employees and independent contractors generally lies in how much control you have over the worker. You can determine the level of control by asking a few questions about the position:
Does your company control or have the right to control over when and how the worker does the job?
Does the company require that the worker show up to perform the work at a specific site or office location?
Will the worker receive benefits?
Is the work engaged for a specific time period?
Is the worker an individual or a business (including LLCs)?
Can the worker take on other work outside of the work your company is requesting?
Per the IRS, “The keys are to look at the entire relationship, consider the degree or extent of the right to direct and control, and finally, to document each of the factors used in coming up with the determination.”
HOW TO HANDLE AN EMPLOYEE
If you determine that the worker is an employee position, you will need to register with your state as an employer, in order to properly set up your company to withhold payroll taxes and . This is required for each state that your worker lives in, so keep this in mind for those employees who work remotely or outside the state that your business operates in.
All employees should meet the Federal and legal requirements for your state in order to be hired, but the first thing they will all need is a W-4, where the worker will provide their legal name, address, SSN, and tax filing status. This information will be included in your payroll system of choice in order to properly withhold appropriate Federal and state taxes. The employee will be paid an hourly rate or salary, which must be established and stay the same unless formally changed. All wages paid and taxes withheld will be reported on a W-2 that you must provide to the employee and the IRS at the beginning of each tax year.
Keep in mind that you will also be held to the employment laws of your state and the state of the employee. Obtain legal advice to be prepared for all of the expectations and requirements of being an employer.
WHAT ABOUT INDEPENDENT CONTRACTORS?
Independent contractor positions are generally expected to be a self-employed individual who performs a professional service for a specified period of time. No Federal or state tax registration is needed when hiring independent contractors, since payroll withholdings are not withheld from their payments.
The first step in hiring an independent contractor is to provide a W-9, where the worker will provide name, address, Taxpayer Identification Number (SSN or EIN), and certification about back up withholding. The W-9 should be kept in your records in case of request by the IRS. Payments to independent contractors that exceed $600 for the year must be reported on a 1099-MISC, which is to be provided to the worker and the IRS by January 31 of the following tax year. Per the IRS, note that independent contractors may have their own employees or may hire other independent contractors (subcontractors). In either case, they should be aware of their tax responsibilities, including filing and reporting requirements, for these workers.
There are pros and cons to hiring independent contractors v. employees, but either way, know which is applicable in your situation.
For more information, use the IRS Small Business and Self-Employed Tax Center as a resource.
DISCLAIMER: I am an accountant, not your accountant. Please speak with a professional about your specific accounting and tax needs before putting any of the aforementioned tips into practice.