Employee vs Contractor: What You Need to Know


When you own a business, there are a lot of big questions to answer. One of the biggest is do I hire a contractor or an employee? 

What is a contractor? 

A contractor is a person that you hire to provide services, but that you have very little control over. By very little control we mean that you don't set their hours, you don't provide the tools needed to do their work, and you control where they do that work. 

What is an employee? 

An employee is someone that you hire to provide services on a part-time or full-time basis. You designate the number of hours they will work, you provide the tools needed to get the work done, you designate where they work will be performed, and in most cases, you designate how the work will be accomplished. 

Why is this distinction important? 

Taxes. When you hire a contractor, you generally pay no federal or state level taxes on their behalf. As a service provider completely independent of your business, you have no tax liability for them (except in one special circumstance mentioned below). 
For employees, you are required to remit payroll taxes as well as quarterly tax filings to both the IRS and the state that the employee is located in. 

Can I just call my employee a contractor if they agree to that designation? 

It's not a great idea. While the IRS will not likely to come after you for this deception (provided you have been filing all the correct contractor documentation), the state in which the employee is located will. The reason for this is that the IRS will still, for the most part, collect Social Security, Medicare, and Federal taxes from the wrongly designated employee when they file their annual taxes, however, the state will never collect workers compensation or unemployment insurance taxes is you don't claim any employees. For this reason, the state conducts random audits on businesses, even if the business states it has no employees. Penalties for incorrect employee and contractor designation can cost more in the end than if you had just paid all the proper taxes. 

What do I need to do if I hire a contractor? 

The two steps in hiring a contractor are 1) collect a W-9 and 2) report their annual payments to the IRS via a 1099-MISC at the end of each year. 

If you don't collect a W-9 from a contractor, by IRS law you are required to withhold 28% of the amount owed to the contractor and remit it to the IRS to cover their taxes owed. The IRS requires this because if the contractor is unwilling to provide a W-9 (which includes their Tax Identification Number), they assume the contractor is not reporting that income and therefore not paying taxes on that income. 

If you paid the contractor more than $600 in the given year, you are required to provide a 1099-MISC to both the employee and the IRS. This ensures that the contractor properly reports income and pays taxes. If you do not file the 1099-MISC with the IRS by Jan 31 of each year, penalties can apply. 

What do I need to do if I hire an employee? 

1.  Decide how you are going to process payroll. There are several options out there. If you already have a bookkeeping software such as QuickBooks or Xero, you can utilize them to process payroll as well. This is the best way to go as it will automatically track your wage, tax, and tax liability info within your current Income Statement and Balance Sheet. 
There are other third-party providers out there such as Gusto, ADP, and Paychex. Each of these has a solid reputation and competitive pricing. 

2. Open up employment accounts with the state your employee is located in. This generally includes opening accounts for workers compensation and unemployment insurance. 

3. Determine a payroll schedule. Will you pay your employees weekly, bi-weekly, semi-monthly, or monthly? When creating this schedule, it is also a good idea to include the schedule of tax payment and filing deadlines. Payroll taxes are due to be deposited on the 15th day after each month. 941's and state employment taxes are usually due the month after each fiscal quarter (April, July, October, and January). 940's are due annually each January. 

4. Collect a W-4 and I-9 from your employees. This will provide all the information that is needed to update your payroll processing tool and pay your employees the proper amount. 

5. Process payroll according to the schedule in step 3 and provide a W-2 to the employee at the end of each year. You will also need to remit a W-2 and W-3 to the Social Security Administration at the end of each year. 

What should I know about payroll taxes? 

Payroll taxes include Social Security and Medicare. The employer currently pays 7.65% of the employees gross wages for these taxes and the employee pays 7.65% of their gross wages for these taxes. 

Federal Income Tax is paid 100% by the employee, but it is the employers' job to remit these taxes to the IRS each month. 

State income and payroll taxes are set forth by the rules of that state. Please consult a CPA or payroll expert for further advice on your state.