Before the pandemic (and all the havoc it created), small business owners were in an ongoing pursuit of sourcing the best workers for their company. Deciding between independent contractors and employees was a frequent question and this debate grew as some states considered enacting laws like California’s 2020 AB5 law. In 2021 “The Great Resignation” arrived and millions of employees have since quit their jobs in pursuit of more flexibility and happiness. This mass exodus has intensified the employee vs. independent contractor debate. With businesses settling into the “new normal” of hiring, entrepreneurs are once again wondering if full-time employees or independent contractors are the best option for this unpredictable phase in recruiting and staffing.
Is Your New Hire an Employee or an Independent Contractor?
The IRS has classification rules for how an independent contractor differs from an employee. This information can help business owners get a better grasp on what’s involved in having employees and working with professionals on a contract basis.
Employees
Employees are workers an employer puts on their business payroll. The employer must register for payroll taxes so that it can withhold money from employees’ paychecks and remit it to the appropriate tax agencies.
When individuals are hired as employees, the employer controls employees’ working hours, work location, tools used, and where they should make work-related purchases. Also, when an employer gives specific directions for how workers should perform their deliverables, the IRS is more likely to classify individuals as employees.
Moreover, elements like worker training and evaluations are considered employer direction, thus usually prompting the IRS to consider workers on the receiving end of those activities to be employees.
Independent Contractors
Independent contractors are self-employed individuals who enter into an agreement (either written or verbal) with a payee to get paid for their services. In the IRS’s classification test, contractors are largely in control of how and when they work. And they are usually responsible for providing the equipment and tools they need to perform their assignments. Although the business engaging contractors controls the end goals, like projects or campaign requirements, independent contractors decide how to accomplish their assigned tasks.
Contractors are not on their clients’ payrolls, and they cannot receive benefits or paid time off like employees. They are wholly responsible for reporting and remitting their taxes (including self-employment taxes) to the IRS, state, and local tax authorities.
Unlike employees, independent contractors issue invoices for their services rendered. Ideally, businesses’ contracts with contractors should contain a beginning and ending date. Contractors should be able to (if asked) show that they earn money through project work and have a variety of clients. Maintaining separate personal and business finances is advised, even when an independent contractor operates as a sole proprietorship. To achieve some legal protection of their personal assets, independent contractors often choose to formally register their small business as a limited liability company (LLC) or C corporation.
Tax Considerations for W-2 and 1099 Employees
There are clear differences between employees and independent contractors when it comes to recordkeeping, employer responsibilities, and how workers are paid.
W-2 Employees
Whether part-time or full-time, employees are subject to a number of taxes by the federal and state governments—and sometimes by the county or city in which they work. Employees must fill out a W-4 (Employees Withholding Certificate) form when hired.
Employee’s Information on the W-4 Form
- Individual’s name
- Address
- Social security number
- Filing status – i.e., Single or Married filing separately; Married filing jointly or Qualifying widow(er); Head of household
- Whether the individual has multiple jobs or a spouse that works
- Number of dependents the individual wishes to claim
- Withholding adjustments
Employers are no longer required to turn W-4 forms to the IRS unless specifically asked for them. The W-4 stays with the company as an official record and is used to determine withholding taxes.
Employee wages are subject to payroll taxes, including federal income taxes, state income taxes, and FICA (Social Security and Medicare). Employers are also required to make a matching employer contribution for the FICA tax. As noted above, some cities also require employees and employers, or just the employee, to pay a local tax, which means the business must withhold the tax from the employee’s paycheck. Finally, unemployment taxes (SUTA) are typically paid only by the employer — the amount varies by state. Only employees in Alaska, New Jersey, and Pennsylvania contribute to their state’s unemployment tax.
Quarterly, employers are required to use Form 941 to report income taxes, Social Security tax, or Medicare tax withheld from employees’ paychecks. Employers must also pay their portion of FICA quarterly.
By January 31 each year, employers must report employee wages and payroll taxes on individual IRS W-2 (Wage and Tax Statement) forms. Employers must send W-2s to the Social Security Administration (SSA) and state, city, and local tax departments. After the SSA processes the form, it transmits the federal tax information to the IRS. Employees must also receive a copy, and a copy stays with the business. In addition, the company must fill out and send Form W-3, Transmittal of Wage and Tax Statements, to the Social Security Administration when sending employees’ W-2s.
1099 Workers
Independent contractors need to fill out IRS Tax Form W-9, which identifies the contractor’s personal information, including social security number or Federal Tax ID number. The business hiring the contractor then submits that form to the IRS.
Businesses do not withhold taxes from payments to independent contractors. Contractors pay estimated taxes quarterly and self-employment taxes on their personal tax forms, which are typically due by April 15.
Businesses must report compensation they made to any independent contractor paid over $600 in a tax year. Payments to independent contractors are reported on Form 1099-NEC, used to report “Nonemployee Compensation.” Up until the tax year 2020, Form 1099-MISC was used by businesses to report independent contractor payments. Some business owners are still unaware of the change, so spread the word! Form 1099-NEC should be filed by January 31 (if January 31 falls on a weekend or holiday, the form is due the next business day). The IRS also requires businesses to submit Form 1096 (Annual Summary and Transmittal of U.S. Information Returns) by January 31. A company’s digital accounting system should be keeping track of the payments it has made and inform it of which independent contractors will need a 1099 form.
State Legislation for Classifying Workers
AB5 (formally known as California’s Assembly Bill No. 5) took the IRS’s worker classification rules and tightened them. California’s law requires that all the following three points must be true for a business to classify a worker as an independent contractor:
- The worker is free from the control and direction of the hirer in connection with the performance of the work, both under the contract for the performance of such work and in fact.
- The worker performs work that is outside the usual course of the hiring entity’s business.
- The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed for the hiring entity.
The change caused a lot of stress and confusion for independent contractors and business owners alike! For more details, I encourage you to visit my past blog post which explains more about AB5’s impacts on classifying workers as independent contractors or employees in California. And stay on the lookout for news in your state about any plans to enact similar legislation down the road. The more you stay in the know, the better prepared you can be for any changes.
Cut Through the Confusion with CorpNet
Many businesses find payroll tax registration and navigating the nuances of working with independent contractors somewhat confounding. Matters can become especially complex when working with employees and contract workers in different states. That’s why it’s wise to enlist the help of a trusted attorney and tax professional to ensure all t’s get crossed and i’s dotted.
And you can rely on my team CorpNet to take the mystery (and mayhem) out of registering your business for state payroll taxes. We have experience working with businesses and the departments of revenue in all 50 states. Also, our specialists can register your business for State Unemployment Insurance Tax (SUI) and State Income Tax (SIT), ultimately saving you a lot of time (and hence money!)
Contact us today for help, so you can get your human resources in order and grow your business.
