Independent Contractors Versus Employees: What's the Difference?

Businesses can often save money by using independent contractors versus employees. However, issuing and processing taxes can become tricky when it comes to independent contractors doing freelance work—especially for small business owners.

To protect your workers and your business, it's important to understand what characterizes independent contractors versus employees so you're ready for tax preparation time.

What are independent contractors?

Hiring independent contractors and freelancers has been a popular business trend since the pandemic as more small businesses have begun looking for ways to streamline expenses and reduce legal responsibilities. But what does it mean to be an independent contractor, and do independent contractors pay taxes or rely on businesses to do it?

The IRS defines an independent contractor as someone who works for a company where the business controls the result of the work instead of how the work gets done. This classification is based more on how work is assigned and completed, rather than by what a business or worker chooses to call the working relationship.

Some independent contractor requirements can help further determine whether someone should be classified as a contractor or employee. While there's no one-size-fits-all solution for an independent contractor classification, there are some significant determinants.

• They provide specific services for projects and assignments under a written contract.
• Their work is governed by a contract end date and specific deadlines.
• They decide how and when the work gets completed within specified deadlines.
• They can simultaneously work on multiple contracts with different businesses.
• They choose their own tools and methods for the work they complete.
• They pay their own self-employment taxes as both an employer and employee.
• They don't receive health or other benefits from the business within the terms of their contract.

Independent contractors are considered self-employed and are subject to self-employment taxes. Unlike traditional employees—who receive Form W-2, Wage and Tax Statement, at tax time—independent contractors receive a 1099 form.

Independent contractors versus employees

There are some key differences between independent contractors and traditional employees. Employees receive specific benefits and protections mandated by law, including unemployment insurance, family leave and regular pay periods. They also typically get benefits like health insurance, although these may not always be required by law. Independent contractors manage most of these costs alone, and they're typically only protected by the contract they've signed.

Classifying 1099 employees versus W-2 workers

It can be challenging for businesses to choose the correct classification when hiring workers, but it's essential to use the right forms so you can avoid paying stiff IRS penalties. Misclassifying employees can also lead to losses in payroll tax revenue, as well as fewer funds from unemployment insurance and workers compensation.

The IRS and US Department of Labor have begun cracking down on employers they believe misclassify employees as contractors, collecting taxes that may have gone unpaid due to the misclassification. To avoid these potentially costly legal and tax issues, it's important to understand the 1099 employee definition to ensure you're classifying workers accurately come tax time.

If you're paying a worker a salary and benefits—as well as collecting and remitting taxes on their behalf—they're considered an employee. In this case, you'd issue a W-2 form, which includes wage and salary information, as well as details about federal, state, and other withheld taxes.

Use a 1099 form for independent contractors or freelancers who earned $600 or more from your business during the tax year. The 1099 form includes information on the total amount of money paid to the independent contractor, as well as their Social Security or other tax ID number. This notifies the IRS that they've earned money through a contract with your business. The contractor is then responsible for calculating and paying their own taxes based on their total annual income for the year.

When it's time to file taxes, have your independent contractors and outsourced service providers complete Form W-9 (PDF), Request for Taxpayer Identification Number and Certification. On the form, the individual or firm indicates that they're operating as a business and designates the business type. To ensure contractors return these on time, you might choose to make their completion a condition of receiving payment.

You'll also need W-9s to accurately create and file Form 1099-MISC, Miscellaneous Income, to report payments to your company made to the service providers. This is a tax filing form designed to disclose miscellaneous payments to non-employees throughout the tax year.

The filing deadline varies from the end of January to the end of March of the following year, depending on what's on the form and whether you file by paper or electronically. A notable exception is that an independent contractor operating as a corporation is exempt, meaning you don't need to file a 1099 for their services.

If you employ individuals who work as sole proprietors for multiple businesses, it's a good idea to create an independent contractor agreement for each to sign. Your contract should make it clear that each worker is serving as an independent contractor by outlining how the relationship will work. To reduce legal expenses, you can modify an existing independent contractor agreement template and review the revision with your attorney.

If you're still unsure which form to fill out, file Form SS-8 (PDF), Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.

The bottom line

Taking these steps helps ensure two things. First, it prevents independent contractors from being classified as employees. Second, it provides the IRS and state governments with the information they need to collect tax revenue properly. Stay protected and compliant by correctly categorizing independent contractors and employees, creating the necessary documentation and tracking their work accordingly.