Small Business Tax Policy

Employee vs. Independent Contractor

The age-old question on any business owner’s mind, is this person working for me an employee or an independent contractor?  It is an important distinction that must be properly classified to avoid months of headaches and thousands of dollars in interest, penalties, and professional fees – and not to mention the hours fighting with the auditor from the Department of Labor. Although hiring an independent contractor is much less costly to the business owner, proper classification from the start will save more money in the long run.  There could be some gray areas in the law, however, most situations are very clear as to how they should be defined.  Follow these simple steps to help you along your path of proper classification.

What is an Independent Contractor?

An independent contractor, generally a business owner that is totally separate from the business in question, is hired to perform a service or project for a business.  They generally have their own business structure, insurance, office space, and equipment.  Your outside lawyer, tax professional, or occasional photographer for photo shoots can generally be classified as an independent contractor.

Benefits of an Independent Contractor

Generally, correctly hiring an independent contractor to complete a project or assignment for your business can save thousands of dollars.  You will not be required to provide unemployment insurance, liability insurance, or overtime pay for any hours worked over forty hours per week. Your business will only be required to provide a 1099 at the end of the year if $600 or more was paid to this contractor.  There are no other payroll requirements, including not being required to pay half of the employment (Social Security and Medicare) taxes.  Along the same lines, no fringe benefits (health insurance, vacation pay, or retirement contributions) are necessary for contractors.  Although there are a great deal of benefits to classifying someone as an independent contractor, the benefits do not outweigh the headaches of potential misclassification.

Consequences of Misclassification

Generally speaking, someone who thought they should be classified as an employee needs to take some action that will trigger an audit.  These audits are usually performed by the Department of Labor, which can require the employer to pay back employment taxes and unemployment insurance payments.  Along with these required payments, there will be interest and penalties dating back to the original due date.  Many business owners will hire an attorney or CPA to represent them during the audit, which could rack up thousands of dollars of professional fees as these audits can drag on for months.  So, although an independent contractor can be less costly to begin with, the potential consequences far outweigh the short term benefits of the misclassification.

Summary

The classification between an employee and an independent contractor is a decision that can cause a great deal of headaches and cost a business thousands of dollars if not done properly from the onset.  Although classification as an independent contractor can save a lot of money in the beginning, it is not worth the consequences of an audit.  Reach out to your trusted accountant to assist in avoiding this issue.

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