Economic factors in recent years have led many businesses of all types and sizes to focus on building a contingent workforce rather than an employee base. While this helps relieve financial hardships for many individuals and companies, it may also lead to some confusion regarding a particular individual’s role within a company. If a worker fails to understand the difference, they may be unaware of the laws and taxes that apply to them. This can lead to serious consequences with the IRS and other government labor agencies for both businesses and workers.
Benefits of Independent Contractors to Employers
It’s common knowledge that employees pay a certain percentage of their income in taxes. However, in addition to the income tax, independent contractors are also required to cover their own payroll taxes. This is the tax that businesses must pay on behalf of each employee (in addition to those employees’ income taxes). In fact, it is also the tax that has led to an influx of independent contractors. By building a contingent workforce, employers avoid their share of the payroll tax, thereby decreasing their operational costs without lowering their overall workforce. However, it also means that workers will have to pay taxes at the end of the year rather than filing for a return.
Costs of Being an Independent Contractor
Why would the worker owe taxes at the end of the year rather than breaking even? In addition to accepting responsibility for their own payroll taxes, independent contractors do not have taxes withheld from their paychecks (since they are considered to be their own bosses). Regardless of how much money a contractor receives from their client, taxes are not withheld since they are not employees. Therefore, in addition to paying the full bill for payroll taxes, contractors must also cover the state and federal withholding, social security and other taxes. This leads most of them to pay their taxes quarterly rather than annually.
Independent contractors are also usually responsible for purchasing the tools and materials necessary for their work. Clients may provide some of the necessary equipment, but it won’t typically be enough to complete the job’s full functions. They are also responsible for maintaining their own inventory levels and ensuring that the right supplies are replenished when necessary. Fortunately, they are also eligible for tax credits on virtually all business related purchases. This can include paper, computers and even vehicle mileage.
Benefits For Being an Independent Contractor
While these expenses may lower the desire to become an independent contractor rather than an employee, the transition is not without its benefits. Unlike employees, contractors are not subject to the 40 hour work week; they are free to garner as many hours and projects as they want without some boss chastising them for it. They also determine their own pay and may change it for different projects based on the required effort.
Independent contractors also enjoy a greater level of independence. While they may be required to follow the client’s outline, they are usually free to perform the work as they see fit. Whether that means rebuilding an industrial machine within their air conditioned workshop or typing away in their pajamas at home, contractors are in control of their work and environment, unlike employees.
Tax Law Relating To Independent Contractors
It’s important to note what the IRS considers the criteria to be an independent contractor. There is no “magic” formula according to the IRS, but here are the factors that must be considered:
- Behavior: Does the company control or have the right to control what the worker does and how the worker does his or her job?
- Financial: Are the business aspects of the worker’s job controlled by the payer? (these include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
- Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?
Basically, if the answer is no to the questions above, the worker can be considered an independent contractor. If you have some “Yes” answers, you probably want to consult a tax attorney prior to classifying any workers.