Employees Versus Contractors

If you are new to payroll processing, it's important to understand the difference between an independent contractor and an employee.

First things first. As a small business owner responsible for processing payroll, you must understand the differences between paying employees and paying independent contractors.

That's because your payroll obligations for employees differ greatly from your payroll obligations for independent contractors.

When you engage an independent contractor, you don't have to withhold or make employer contributions for payroll taxes.

Your only payroll requirement is to issue a 1099-MISC form once a year to each contractor. You need to submit one 1099-MISC for every contractor to whom you've paid $600 or more during the course of the year.

When you engage an employee, you are liable for withholding, timely remittance, and reporting various taxes to the federal, state and local governments.

Your obligations include taxes withheld on behalf of employees, such as federal income taxes. They also include taxes owed by you, the employer, for your employees such as state unemployment insurance and the employer portion of Social Security.

Deciding whether someone is an employee or independent contractor can have serious consequences for your company.

Taxes deducted from gross pay include federal (and state and local where applicable) income tax, Social Security and Medicare contributions. All of these come out of the employee's pockets.

What many people don't realize is that the employer also pays substantial taxes for each and every employee. Employer taxes cover Social Security and Medicare taxes, as well as all of the unemployment and workers' compensation insurance premiums.

Those employer taxes are only paid for employees, not for independent contractors. Independent contractors pay both portions of the taxes themselves.

As such, less money comes out of an employer's pocket for employment taxes when they engage an independent contractor, rather than an employee.

In other words, it may be financially advantageous to hire independent contractors, rather than employees.

On the flip side, because independent contractors know they need to cover hefty employment taxes, including the employee and employer portions, and provide for their own benefits, they will likely increase their rates to cover those costs. Is it a better deal to hire an employee or an independent contractor?

It all depends on how much you have to pay them - one isn't implicitly more cost effective than the other. You'll have to do the math and find out.

Beyond the math, to qualify as an independent contractor and not an employee, the role must meet a set of criteria established by the government.

Misclassifying an employee as a contractor can result in penalties and back taxes, so talk to a qualified tax advisor before you assume that a contractor is not an employee.

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