When you bring someone on to help your business, one of the first questions is whether that person is an employee or an independent contractor. The answer is not a matter of preference or of what the paperwork says. It depends on the actual relationship. Getting it right determines whether you withhold taxes, pay employment taxes and which forms you file.
Why classification matters
The IRS page Independent contractor (self-employed) or employee? explains that it is critical for business owners to correctly determine whether the individuals providing services are employees or independent contractors. Generally, you must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to an employee. You generally do not have to do these things for payments to independent contractors.
The general rule
The IRS describes the general rule this way: an individual is an independent contractor if the payer has the right to control or direct only the result of the work, and not what will be done and how it will be done. The earnings of a person who is working as an independent contractor are subject to self-employment tax.
The three categories of evidence
The IRS groups the facts that show the degree of control and independence into three categories.
Behavioral control
Does the business control, or have the right to control, what the worker does and how the worker does the job? Detailed instructions, required methods and training on how to do the work point toward employment.
Financial control
Does the business control the business aspects of the job? This includes how the worker is paid, whether expenses are reimbursed, who provides tools and supplies, and whether the worker can make a profit or loss.
Type of relationship
Are there written contracts or employee-type benefits such as insurance, a pension plan or vacation pay? Will the relationship continue, and is the work performed a key aspect of the business?
No single factor decides the question. The IRS looks at the relationship as a whole. If it remains unclear, the IRS page explains that either the business or the worker can request a determination using Form SS-8.
Forms involved when you hire a contractor
The IRS page on forms and associated taxes for independent contractors explains the typical paperwork:
- Form W-9. Have the contractor complete Form W-9, Request for Taxpayer Identification Number and Certification, to provide their correct name and taxpayer identification number. Keep it on file for four years.
- Form 1099-NEC. If you pay an independent contractor at or above the reportable threshold during the year, you may need to file Form 1099-NEC to report nonemployee compensation. Check the current form instructions for the threshold and deadlines.
Collect the W-9 before the first payment. Chasing tax identification numbers in January is one of the most common year-end headaches.
Forms involved when you hire an employee
Employees are handled through payroll. They complete Form W-4 so you know how much federal income tax to withhold, and you report wages and withholding through employment tax returns and Form W-2. Our article on employment taxes for new employers covers the basics.
Practical steps for owners
- Before hiring, write down how the work will be directed, paid and supported.
- Compare those facts against the three IRS categories.
- Collect a W-9 from every contractor before you pay them.
- Record contractor payments in a separate account in your books so year-end reporting is straightforward.
- Revisit the classification if the relationship changes, for example if a contractor starts working set hours under your direction.
This article is general information. If a classification is unclear, review the IRS guidance and consider talking to a qualified tax professional.
How we can help
We help businesses keep contractor records organized and payroll running smoothly. Learn more about our payroll services and bookkeeping services, or book a free consultation.
