Recent studies show that in the US, small businesses account for over 70 percent of the available jobs. Many of these successful small business owners say that one of the things they love the most about owning their own business is the ability to provide jobs and income to other people.
If you haven’t already, at some point you will likely hire other people to help you in your business. It may be a secratary to help you organize all your administrative work or it may be another person who does what you do, so you can expand your operations. The ability to give someone a job that they otherwise wouldn’t have had can be very rewarding and can help ease the burden and hours you put into running your business.
But be warned, there are two very different types of hires. And choosing the wrong one could cost you thousands of dollars in taxes and/or penalties.
Employee vs. Independent Contractor
When hiring a person to assist you in your business, there are generally two categories you can choose to hire them under: employee and independent contractor. Each one comes with its own rules, regulations and tax consequences.
Here are the general characteristics of each type of hire:
- The company controls when the person must work, how they must conduct their work and where they must do their work.
- Usually has a written up long-term employment contract.
- Often includes benefits other than pay, such as health benefits, retirement benefits and vacation and sick pay.
- Taxes must be withheld by employer for income taxes, medicare and SS taxes and unemployment taxes.
- Employer is required to pay workers comp and other insurances.
2. Independent Contractor
Worker determines when, where and how job will be performed.
- Employer is not required to pay or withhold any taxes for worker.
- No benefits provided other than pay.
- Usually operates on a project basis, not a long-term contract.
- No workers comp or other insurance required to be paid by employer.
The easiest way to determine whether your recent hire is an employee or independent contractor is the question of control. If you control when, where and how they perform a task, they are probably an employee. If the worker controls when, where and how they perform a task, they are probably an independent contractor.
Which is Better
As with most areas of the internal revenue code, the question of whether an employee or independent contractor is better for you depends on your own situation.
If your biggest concern is saving money, independent contractor is the easy choice. You pay them only when you have a specific project for them (as opposed to a long-term employee contract), you don’t have to pay any additional benefits, and most importantly, you pay absolutely no payroll taxes. The payroll taxes alone could save you tens of thousands of dollars over the course of the year, depending on how much your hire is being paid.
If you are more concerned with how the job gets done and having someone consistently available to perform various jobs, an employee may be your best bet. With an employee, you set a pre-determined work schedule that requires them to show up at set dates and times. You control how the work gets done and when it is done by. You will pay significant money in various payroll taxes and insurances, but for many businesses these additional costs are necessary to have the control they need over their hires.
What Happens if I Choose the Wrong One
For most new businesses, an independent contractor is far more appealing than an employee. The savings in payroll taxes alone make it much easier to hire someone and the flexibility of only using them when there is specific work to be done can save significant money in the early stages when the amount of work is still uncertain.
But you must tread lightly when labeling a recent hire an independent contractor. If it is later determined that your independent contractor was actually an employee, you could be responsible for huge sums of money in back taxes, interest and penalties.
You should also take the time to explain to your new hire their responsibilities as an independent contractor. I have seen many cases where the independent contractor was unaware they would be responsible for their own taxes and tried to appeal to the IRS that they were actually an employee. This creates a big mess that you do not want to deal with, even if the worker is rightfully an independent contractor. By explaining to them ahead of time that they will be responsible for any and all of their own payroll taxes, you may keep the IRS out of the decision.
The bottom line when it comes to making the distinction between an employee and independent contractor is to use common sense. By trying to classify a recent hire who is obviously an employee as an independent contractor, you will likely end up paying far more money than you would have saved.