The Tax Implications of Independent Contractors

Are your employees really employees, or are they actually independent contractors? It's not just semantics; the IRS makes a stark distinction. You don't generally have to withhold or pay any taxes on payments to independent contractors, as you do with employees.

If you're unsure about the tax implications of hiring freelancers versus employees, check out our blog on Employee vs. Freelancer: Tax and Financial Implications for Business Owners.

If you're a business owner hiring or contracting with other individuals to provide services, consider the following:

• What degree of control and independence is there in the contractual arrangement? Does your company control or have the right to control what the worker does and how the worker does his or her job?
• Do you control the business aspects of the worker's job? This includes considerations like how the worker is paid, whether expenses are reimbursed and who provides tools and supplies.
• Are there written contracts or employee benefits such as a pension plan and vacation pay, and will the relationship continue? Is the work performed a key aspect of the business?

You need to weigh all factors when determining whether a worker is an independent contractor. The key is to look at your entire relationship and decide the degree or extent of your right to direct and control how he or she works. Document each factor used in arriving at your determination.

Independent Contractors

If the worker in question is an independent contractor, have them complete Form W-9, Request for Taxpayer Identification Number and Certification. Do this before you begin paying them. Keep the W-9 in your files for four years for future reference. Do not have them submit Form W-4, which is only for employees.

Next, if you paid more than $600 in a calendar year to a non-employee, use 1099-NEC to report payments of non-employee compensation. (Form 1099-NEC recently replaced Form 1099-MISC for the payment of independent contractors.) A copy of 1099-NEC must be provided to the independent contractor by Jan. 31 of the year following payment and you must submit a copy of this form to the IRS as well.

You can file these forms electronically. There are multiple services available to file these forms or you can ask your CPA to do so for you.

Working with independent contractors offers flexibility, because you don't have to set up a new department to get the task done. Contracting doesn't involve the same amount of paperwork that goes with hiring an employee, either. And there are fewer payments to the IRS, as you don't have to match payments of taxes such as Social Security tax or pay unemployment tax. Just make sure not to misclassify an employee as an independent contractor to avoid federal fines and penalties.

Properly classifying your employees can be complex. If you have concerns about how to classify your employees, it may be prudent to consult with an employment attorney as this is a complicated topic and there may be other issues to consider that are not tax-related.