Have you made the mistake as a small business owner thinking you have hired an independent contractor, only to find out from the IRS that they are in fact an employee because of the outlined relationship and now owe back taxes including penalties, fees and interest? Before hiring any independent contractor or freelancer you should be absolutely aware of how that relationship needs to be structured in order to avoid paying employment taxes.
Independent Contractor or Employee
Sometimes the most difficult choice for businesses is determining whether they want to hire an employee or a contractor. General wisdom dictates that independent contractors can save small businesses up to 30% in costs over a full-time employee. Unfortunately, too many business owners take advantage of the contractor-business relationship that puts it in danger of becoming an employer-employee relationship with all the tax implications that come with it.
On the other side of the coin is the self-employed contractor or freelancer. As one of these individuals you have to be aware that you are liable for your own income tax filing and tax remittance. If your tax liability will be more than $1000 per year than you will also be required to pay estimated taxes, essentially paying your Social Security and Medicare taxes of the Self-Employment tax on a quarterly basis, estimated by your previous filings or current accounting records.
You must pay self-employment taxes if you earn more than $400 per year at your contractor or freelancer endeavours. In order to pay these taxes you will need a SSN or Individual Taxpayer Identification Number (ITIN)
Determining the Relationship
In determining the relationship between business-contractor three main common law rules are considered by the IRS. These include behavioral, financial and type of relationship.
The most important aspect usually considered is the behavioral component of the relationship between the company and the contractor. If the company has any behavioral control over the contractor including how and when a job is completed, the relationship is generally considered an employer-employee relationship. For example, if the business states specific hours for work for the contractor or lay out exact job descriptions on how the work should be completed you are essentially describing an employer-employee relationship and will be subject to Employee Taxes.
The second aspect considered is the financial control of the relationship. If the payer controls how the contractor is paid, such as weekly on Thursdays, as opposed to an invoicing system or whether expenses are reimbursed or even if the business provides tools for the contractor, these can all determine an employee relationship.
Lastly, the type of overall relationship is considered such as whether the contractor receives benefits such as a pension, medical insurance and vacation as well as, is the work performed a key aspect of the business. All three factors should be considered especially for the tax bill that could come from an employee determination over that of a contractor.
Whether you are the contractor or you are the business owner, ensure the relationship with the other party falls under the appropriate guidelines as laid out above and by the IRS to avoid surprise taxes.