May 03, 2023

Is This Your Situation: Deciding Whether Someone Is an Employee or a Contractor

What is in a name? The IRS knows the answer, even though the reasoning can be subtle. Read on to learn the differences between an employee and an independent contractor before you make an expensive error.

Many companies use both employees and freelancers, and this is fine, but the IRS doesn't treat them as interchangeable — there's no mixing and matching. Anyone you pay is either one or the other and subject to the proper tax treatment.

So which is which? You're probably wondering about the functional difference between an employee and a contractor. So, let's start with employees. The IRS defines an employee relationship as one in which you, the employer, "can control what will be done and how it will be done." Employees are generally given training, resources and benefits. They have a portion of their pay withheld for taxes.

What Determines Independent Contractor Status?

For the most part, independent professionals who offer their services to the public are considered independent contractors. This description includes doctors, accountants, lawyers, photographers, designers and writers. Unlike in an employee relationship, you as the payer relinquish a portion of control over the contractor's time. You still dictate fulfillment of an agreed-upon task, but you are not in control of the contractor's means of completion.

Independent contractors pay self-employment tax on their earnings, while employees typically have taxes withheld.

What Are Statutory Employees and Statutory Nonemployees?

These terms can be confusing, and although there's a good chance you won't be dealing with them, you may hear the terms. Just so you understand the concepts, contractors may be considered statutory employees if they fall within various IRS specifications. Social Security and Medicare taxes may be withheld if a statutory employee a) performs all service personally, b) does not have an investment in the work equipment and property, and c) performs the work on a continuing basis.

Statutory nonemployees are usually direct sellers or real estate agents. They are self-employed for tax purposes if a) their wages are related to their output rather than the number of working hours and b) they work under a written contract specifying that they are not employees.

Common Law

There are three common-law categories to weigh when determining whether your worker is an employee or a contractor: behavior, financials and type of relationship. Do you have control over how the worker does the job? What are the financial agreements? Are you providing additional benefits? These types of questions help paint a bigger picture and eventually lead you to a final answer.

Withholding and Record-keeping

Once you've sorted out who is who, it's easy to figure out how to treat each group. For employees, you must withhold income, Social Security and Medicare taxes. You will deposit and report the withholdings in accordance with the IRS guidelines in Publication 15, Employer's Tax Guide. Each year at tax time you issue a Form W-2 to each employee.

For independent contractors, on the other hand, you do not have to withhold taxes. And instead of the Form W-2, you send each one a Form 1099-MISC.

Even experienced managers may have trouble distinguishing between an employee and a contractor. So please don't hesitate to give us a call about any current or contemplated worker relationships. We'll be happy to help you sort everyone out according to IRS guidelines.

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