Employee or Independent Contractor? Why you must know the difference

The distinction may be challenging to make sometimes, but the IRS has very strict rules about it.

Depending on the size of your business, onboarding a new hire can involve a lot of reading and writing for both of you. You may want the new worker to fill out a personal profile. There might be a company handbook, detailed job specifications, a slew of passwords and logins…and tax forms. 

But which tax forms? That depends entirely on whether your new team member is an independent contractor or an employee. The distinction involves more complex issues than their actual physical work location (your office or elsewhere) and their schedule (full-time 9-5 or an odd assortment of part-time hours). 

The U.S. Department of Labor and state labor departments take this distinction very seriously. So seriously, in fact, that they’ve been known to do lengthy investigations of large companies to determine whether staff members are being classified correctly.

You’ll need to determine whether workers are employees or independent contractors, so you know which tax form to send in January—a 1099-NEC or a W-2.

Easy-peasy, right?

Not exactly. Though federal and state labor departments lay out the criteria used to determine worker classification, there’s no simple formula and the criteria can seem pretty ambiguous. From a broad perspective, you should consider three main elements of the relationship between management and workers as you try to make this call— 

• Behavioral. How do the workers do their jobs, and what do they actually do? Does the employer control this or the employee/contractor?
• Financial. Do workers pay for their own computers, smartphones, and the other supplies and tools required to do their jobs, or does management? How are individuals paid? Are their expenses reimbursed?
• Type of relationship. Will this be an ongoing relationship? Are there “extras” involved outside of basic compensation, like employee benefits (health insurance, retirement plans, etc.) and written contracts? Will the new staff member be providing a work product that is a “key aspect of the business”?

It’s a question of control. How much control does the boss have over a worker? You may get frustrated as you try to answer these questions. It may seem that some of your answers would indicate that the individual is an independent contractor, while others point to employee status. You might also discover that some of the individual’s work and workdays fit one classification while other work would fit the other. 

The tax piece

When you recruit a new worker, you’ll need to know immediately whether the worker is an employee or an independent contractor, so that you know which IRS tax form you need to have them complete before you pay them for the first time. 

An independent contractor should fill out a W-9. Contractors typically submit invoices for work performed, you pay them, and they’re responsible for their own income taxes. So, as the employer, you are not required to withhold, nor pay, any tax on their behalf. An employee, on the other hand, should complete a W-4 . As the employer, you are then required to withhold and make tax payments.

We encourage you to contact us if you’re having trouble distinguishing between employees and contractors. We want to help you make the right decisions for your business.