Understanding the differences between payroll employees and independent contractors is key in making a decision that every business has to face: would it be better to hire a contractor for this job, or should I put the person in charge of this job on my payroll?
The major difference is one that many people are familiar with: employer tax obligations and tax withholding. Independent contractors are responsible for their own tax liability. Payroll employees, on the other hand, must have their federal and state income tax, Social Security, Medicare taxes, and unemployment taxes automatically deducted from their paycheck.
It is important to note that this is not the only distinction, and that you should not decide solely on this basis. In recent years this has been a hot button issue with the IRS and many State agencies. We have seen an increase in audits specifically targeting the improper classification of payroll employees and independent contractors. The overall question is, who controls the relationship? There are three key areas you need to evaluate before determining if a given position should be hired out to a contractor or put on payroll: behavioral expectations, financial control, and relationship.
The extent to which you have influence over the person performing the task required for a given position is key to figuring out if you need a contractor or a payroll employee. If you need to give instructions like where and when they need to work and what tools they may or may not use, this may be a position more suited for a payroll employee. Additionally, if the employee needs to be trained extensively, this is a good indication that this should be a payroll employee, as independent contractors are typically skilled professionals hired for the pre-existing knowledge they bring to the job at hand.
If you need to make a significant investment in the equipment the worker requires and/or pay the worker at a regular rate, such as an hourly, weekly, or yearly salary, this position is probably better suited to a payroll employee. If, however, you charge a flat fee for a given task, or leave the risk and reward of profit and loss to the worker, the position is probably better suited to an independent contractor. This distinction will come into play upon hiring, as the paperwork is also different – payroll employees need to complete a W-4 and I-9 on their first day, leading to a W-2 to be generated for them around tax time, and independent contractors need to complete a W-9 to generate their 1099 during tax season.
One of the most important aspects of this area is the permanency of the position. If the position is temporary, or at least short-term, this is clearly more suited to contract work. However, if you have an ongoing need for this position, a payroll employee might be the wiser choice. Remember to factor in whether or not you want to extend employee-type benefits to the person that will be employed in this position. Contractors may see this as an added perk, but to a payroll employee, it may be a requirement of the position.
Whether you choose to have all payroll employees, all contractors, or a hybrid, the team at MD Andersen, CPA, PA can guide you in making the decision while remaining tax compliant. Reach out today if you need help or more information regarding the distinction.