When you hire someone to help you with your business, they are classified as either an “employee” or an “independent contractor” for tax purposes. Knowing which classification applies is important to you because it lets you know what taxes to withhold, if any, and what tax forms to file.
From your perspective as the hiring company, the main difference between the two is that you are not responsible for payroll taxes for independent contractors while you are (and must pay the other half of social security and Medicare) for employees. So looking at it strictly from a financial perspective, you save money when you have independent contractors rather than employees. Unfortunately, the decision regarding which classification you choose is not solely up to you. The IRS has the ultimate say and can “reclassify” your workers if they disagree with your assessment (and, of course, can assess penalties if they decide your independent contractors are actually employees).
The IRS looks at three things when they evaluate whether a worker should be classified as an employee or an independent contractor:
- Behavioral Control. This relates to whether your company has the right to control how the work to be done is actually done.
- Financial Control. This relates to whether your company has the right to control the financial and business aspects of the worker's job.
- Type of Relationship. This relates to how you and your worker perceive your relationship.
Basically, the more control you have over your worker – telling them where to be, when to be there, and what and how to do their job – the more likely they will be considered an employee. Independent contractors are, not surprisingly, independent and can choose when they work, where they work, and how they get the work done. They also frequently have more than one source of income (i.e. you're not the only one they work for), use their own tools and equipment to get the job done, and operate under an entity rather than individually as a sole proprietorship. If you plan on working with someone as an independent contractor then it is very important (and can help you if the IRS looks into your situation) to have a written independent contractor agreement.
The IRS web site has more information on the analysis of the independent contractor versus employee issue and offers tips to help you decide. When bringing on someone new to help with your business, it's important to look closely at the factors so that you choose correctly.