One of the most important decisions faced by an entrepreneur with a growing business is when to start hiring outside help. Carefully selected and trained employees can be an invaluable asset to the business, returning many times their own cost in sales or productivity gains. On the other hand, the wrong people (or the right candidate at the wrong time) can be disastrous. Given the cost and complexity associated with on-boarding employees, many entrepreneurs choose to retain contractors either as an interim step or as a lower cost alternative to a permanent workforce. However, a “contractor” may actually be an employee under federal or state law, regardless of any agreement between the employer and worker to the contrary.
Contractors Cost Less Than Employees
Federal law requires employers to withhold and remit taxes on income earned by their employees on a periodic basis and also to pay the employer’s portion of Medicare, Social Security, and Unemployment Taxes. State laws impose additional withholding and tax requirements. Once insurance mandates, benefits, and other expenses are factored in, the true cost of an employee may be 25% or more higher than the agreed upon salary. There is usually no withholding requirement for contractors, nor any requirement to provide health insurance or unemployment coverage.
“Contractors” may be a low-cost alternative to employees, since contractors are entitled only to the agreed price for their labor and a 1099 form at the end of the year. Contractors generally do not enjoy unemployment insurance coverage and no withholding is required.
When A Contractor Is Actually An Employee
The IRS and other regulators look beyond the simple 1099 form or W2 form distinction that many companies use to define contractor status. Instead, a variety of common law tests and other classification regimes have been developed. Misclassification of an employee could result in serious penalties, interest charges and back taxes.
The IRS provides no definitive rules that instruct employers how to classify their workers. Instead, the agency relies on the specific pattern of facts for each worker and employer relationship, with a focus on degree of autonomy. For example:
- Does the company control or have the right to control what the worker does and how the worker does his or her job?
- Are the business aspects of the worker’s job controlled by the employer? Examples would be work rules, ownership of tools, expense reimbursement arrangements, etc.
- Are there written contracts or employee type benefits? Also, does the worker occupy a key position or have a long term relationship with the employer?
Misclassification Can Be Costly
In our experience, the vast majority of “contractors” employed by small businesses would likely be considered misclassified employees by the IRS. If you are unsure whether a worker would be considered an employee, you can file form SS-8 with the IRS to request a “worker status” determination. Note that a worker can also file this form, which could create problems in the event of a dispute with an employer. Also, a determination in response to form SS-8 may or may not be honored by other regulators or state agencies.
Hiring your first round of employees is a big step. A small investment in planning may save your company from substantial inconvenience in the future. We provide accounting and tax services to help keep you straight. Contact us for a free consultation.