Employee vs. Independent Contractor – Tips for Business Owners
If you are a small business owner, whether you hire people as independent contractors or as employees will impact how much taxes you pay and the amount of taxes you withhold from their paychecks. Additionally, it will affect how much additional cost your business must bear, what documents and information they must provide to you, and what tax documents you must give to them.
Three characteristics are used by the IRS to determine the relationship between businesses and workers: Behavioral Control, Financial Control, and the Type of Relationship.
1. Behavioral Control covers facts that show whether the business has a right to direct or control how the work is done through instructions, training or other means.
2. Financial Control covers facts that show whether the business has a right to direct or control the financial and business aspects of the worker’s job.
3. The Type of Relationship factor relates to how the workers and the business owner perceive their relationship.
It is critical that you, the business owner, correctly determine whether the individuals providing services are employees or independent contractors. Generally, you must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to an employee. You do not generally have to withhold or pay any taxes on payments to independent contractors.
Think of it like this:
To be classified as an independent contractor:
- Business owner can specify “what” is to be done not “how” (Control Test)
- Does the person in question have their own tools, business cards, and invoices?
- Best Answer – Have the independent contractor set up an LLC.
Advantages of having the independent contractor set up a separate LLC
- Separate legal entity
- Contractor can now benefit from business tax planning
- Contractor can set up compensation, fringe benefit, and retirement planning
- Significantly reduces audit risk for both parties