As a business owner, you already know that certain decisions you make can have tax impacts on your business. When it comes to choosing between contract labor or hiring employees, there are pros and cons to each side. It is important for you to understand the differences between these options and how they could affect your taxes or the implications for your taxes and revenues. It doesn’t matter if you’re a business owner, freelancer, or a full-time worker; knowing how these tax responsibilities differ between the two classifications can ensure you stay in compliance, avoid costly penalties, and make an informed financial decision.
In this guide, we will further explore the key tax differences between independent contracts and employees and why those differences matter.
Classification Basics: Who’s Who?
Let’s start by first defining what each term means. Before you can really understand the tax implications, you need to know what the difference is between contract laborers and employees.
- Employees typically work under the control and direction of an employer. If they are your employees, then you are the employer and therefore the director. Employees typically have set schedules and perform specific duties that are defined by their employer and their job descriptions. These employees can receive benefits such as health insurance or paid leave, depending on what the business has available to them.
- Independent contractors are self-employed individuals or individuals employed through a third party. These individuals provide their services to businesses. They can usually set their own hours and prices, and they will determine how to complete the assigned task as well as be responsible for invoicing you for your work.
Employees receive a W-2 from you that cites their earnings and contractors receive a 1099 for their work and how much you paid them. If you misclassify a worker, this can lead to tax penalties and potentially other legal issues, so you want to get it right from the beginning.
Tax Withholding: Who Pays What?
When it comes to tax withholding and who pays what, there are very strong differences between contract laborers and employees. Let’s take a look.
Employees have taxes automatically withheld from their paychecks. This includes:
- Federal income tax
- Social Security tax
- Medicare tax
- State and local taxes (where applicable)
With employees, employers must match the Social Security and Medicare contributions, pay unemployment taxes, and report the wages earned via a W-2.
Independent contractors work very differently from employees. They:
- Receive full payment with no taxes withheld
- Are responsible for calculating and paying their own taxes, typically through quarterly estimated tax payments
- Must cover both the employee and employer portions of Social Security and Medicare taxes via self-employment tax, currently totaling 15.3%
The business hiring the contractors is not responsible for any withholding. The only reporting required is to issue a 1099.
Forms You’ll Encounter
The tax forms used will vary between employee and contractor, much like your filing or withholding and payment requirements. For your employees, you handle all of the back end filing and withholding. You issue your employees’ paychecks at the stated pay periods, and each paycheck has details of itemized deductions. At the end of the year, you issue them a W-2 that reflects wages, withholdings, and more so they can use that data to file their tax returns. What you pay your employees is an expense you can claim as well.
The independent contractor will be paid based on what they bill you for services. Unlike your employees, there is no need for the tax withholding and reporting. There is just an exchange of services and payment for services. You will issue them a 1099 if their services earned more than $600 in a single year. If you do not provide a contractor a 1099, you cannot claim the expenses for your business.
These differences shift the burdens of tax filing as well. Most employees can file a straightforward return, while contractors will need to file the appropriate business return forms.
Deductions and Business Expenses for Contract Labor
One of the biggest tax benefits for independent contractors is the ability to deduct a wide range of business expenses:
- Home office costs
- Internet and phone bills
- Office supplies
- Travel and mileage
- Continuing education and certifications
These deductions help reduce taxable income, but require careful documentation and proof that the expenses are business-related.
Employees, meanwhile, have more limited deduction options. Since the Tax Cuts and Jobs Act of 2017, unreimbursed work-related expenses are no longer deductible for most employees.
Audit Risks and Recordkeeping for Contract Labor
The IRS scrutinizes independent contractor filings more closely due to the potential for misreported income or exaggerated deductions.
Contractors should:
- Keep detailed records
- Save all receipts and invoices
- Separate business and personal finances
Employees, who have less flexibility in deductions, are less likely to face audits for work-related filings, although other types of tax issues can still trigger reviews.
Business Implications: Hiring Contractors vs. Employees
From a business perspective, hiring independent contractors can reduce overhead:
- No need to pay payroll taxes
- No benefits or unemployment contributions
- Flexible, project-based work arrangements
However, the IRS keeps a close eye on potential misclassification. If you control how, when, and where a person works, they may legally be an employee, even if both parties agree otherwise. Employers who misclassify employees as contractors could owe back taxes, penalties, and interest. This is why it is so important to fully understand the differences and react accordingly for documentation and filing purposes.
Making the Right Choice
Which is the best fit is going to depend on your business and even your preferences. These are important questions to consider:
- Who controls the work and schedule?
- Who provides tools and materials?
- Is the relationship long-term and ongoing?
Know all the details, and ensure you work with a CPA before making any final decisions. You should know how your decision will affect you, whether you are a worker or a business.
Contract Labor vs. Employees? Work with Katherine M Johnson, CPA, for Tax Support
No matter your business design, we are here to help. The professionals at Katherine M Johnson, CPA, work to help you understand your options and ensure proper reporting and tax filing no matter which option you choose. Contact us today to get the support you need!
Recent Comments