It is extremely important to understand the difference between an employee vs. a contractor. The IRS takes this distinction very seriously, and there can be legal ramifications if you don’t follow the rules and guidelines they lay out. Therefore, if you are a small business with an LLC (or any business structure for that matter), you need to be familiar with the critical differences between these designations.
This article will take the IRS guidelines and break them down to help you better understand the information they provide on the difference between employees vs. contractors.
Employee vs. Contractor: An Overview
Under the classifications mentioned above, you can bring on help in the form of an actual employee of your business, or you can outsource work to a contractor. Depending on the structure you set up, an employee will provide more support, while a contractor can be easier to manage with less overhead.
If you decide to bring employees on staff, you'll be responsible for withholding taxes for those individuals (including unemployment, social security, Medicare and obviously income).
When you are working with a contractor, you do not need to withhold any of the taxes mentioned above. Instead, it's the contractor's responsibility to pay for their own taxes as a self-employed individual. Depending on the total amount the contractor makes, they may receive a 1099 tax form from your business. This generally takes place if the contractor is paid more than $600 for the year from any given business he or she works with.
Three Categories to Classify Employee vs. Contractor
The IRS breaks down the differences between an employee vs. contractor by looking at three different categories: behavioral control, financial control, and relationship. Below we'll discuss how the IRS classifies each to give you a better understanding and allow you to decide which you prefer for your own business.
1. Behavioral Control
This category deals with the amount of control a business has over the type, location, amount and timeline of work that needs to be completed. If the business is dictating everything, generally the person on the other end will be classified as an employee. This is like a regular 9 a.m.-5 p.m. job: the business tells you what work to complete at a certain location, as well as when you should complete it. If the company trains someone on how to do a certain job and/or provides ongoing training, that person is likely an employee.
In contrast, a contractor can usually work from anywhere they wish. Contractors have the ability to work whenever they want and are not confined to the normal 9 a.m.-5 p.m. hours that many businesses follow. A contractor also is usually responsible for their own training; these specifics are not dictated by any single client they work with.
2. Financial Control
How someone is paid and how they get paid can also help differentiate an employee vs. contractor. If a company is paying an individual weekly or bi-weekly and controls the amount paid (i.e., a fixed amount or given salary), the individual is considered an employee. Employees generally get paid for working a designated timeframe, such as eight hours a day or 40 hours a week. Companies will also usually reimburse expenses an employee incurs, such as for travel or lodging related to work. Finally, a company can dictate that their employees only make money working with them via non-compete agreements or other contract stipulations.
This is different from a contractor, who is generally paid by the job or when a task is completed, and commonly earns a fixed fee designated by the contractor themselves. Contractors also must pay for any unreimbursed business expenses out of their own pocket, and they are free to work with whoever they want and make money from any business they wish to provide services to.
For this category, it all comes down to how the individual and the business interact. There can be contracts in place for both employees and contractors...but the wording is what determines an employee vs. contractor relationship with the company.
A contract signed by an employee will usually state things like:
- Their employment status with the company
- Position held
- Hours or schedule required to be worked
- Job duties or responsibilities
- Benefits (including insurance, pension, vacation, sick time, etc.)
If there is an expectation for the person to indefinitely work with the business, that individual is most certainly an employee.
However, if the contract spells out things like how a project will be handled, a timeline of completion, and how and when someone will be paid, that individual is generally a contractor. A contractor does not get any sort of benefits (vacation, retirement, 401k, etc.) from a business they work with. In addition, a contractor is free to come and go when working with the company, as long as they don't violate the terms of their own contract.
Hopefully the above information has helped you understand what constitutes an employee vs. a contractor. Knowing the difference is extremely important, since misclassifying an employee can cause you to incur financial penalties and legal ramifications from the IRS.
Don’t be afraid to start your own business just because of all the rules and regulations. If you need assistance to manage your business, Incfile can help. Allow their knowledgeable staff to keep your business in good standing. You can even have them file your taxes for you if you wish. Contact them today!