Here are the fundamental differences that govern the tax treatment of an independent contractor vs employee, which every taxpayer should know.
In this article:
- State and Federal Income Tax
- Social Security and Medicare Tax
- Unemployment Tax on Wages
- Required Forms
4 Tax Treatment Differences Between an Independent Contractor VS Employee
Businesses’ Level of Control over Independent Contractors VS Employees
Before discussing the tax treatment differences inherent to working with independent contractors and employees, first, we must explore what makes these two categories distinct. The distinctions boil down to the level of control a business has over its workers.
Both independent contractors and employees accomplish work on behalf of an employer or business. But while employers can demand when, where, and how employees do their job, as agreed upon in a signed contract, independent contractors usually render their service as they deem fit, so long as they deliver.
Independent contractors mostly rely on their own resources (from contacts to computers) to accomplish their deliverables. This, on top of their expertise, allows them to charge higher service fees compared to employees.
Examples of work that are often outsourced from independent contractors include:
- Data gathering and analysis
- Creative services (writing, editing, graphic design, photography, and the like)
This should help better contextualize how and why the tax treatments differ between these two types of workers.
1. State and Federal Income Tax
One of the first major decisions a businessperson has to make is whether to hire an independent contractor or an employee to carry out the accomplishment of their goals. This decision directly affects business management.
For one thing, employees are protected by federal and state labor and employment laws, unlike independent contractors who are not subject to these statutes. This means that employers automatically assume a bigger legal responsibility toward their hired employees.
Another direct effect of the aforementioned decision to business management is in terms of taxation. Working with an independent contractor exempts a business from participating in certain tax processes required of an employer.
This exemption includes withholding state and federal income tax. An employer must automatically deduct a certain percentage of their employees’ wages on a regular basis.
The specific amount an employer needs to withhold from a worker’s salary depends on the latter’s Form W-4 and the withholding tables issued by the IRS. This, alongside the withholdings deposit schedule, is discussed in the Employer’s Tax Guide.
Some businesses resort to employee misclassification to evade tax responsibilities associated with employment. The IRS considers this a serious offense.
Employee Misclassification Definition: The unlawful practice of labeling hired employees as independent contractors, which significantly reduces labor costs to the detriment of workers’ rights as well as federal and state tax collection.
2. Social Security and Medicare Tax
Social Security is the country’s financial safety net for its people. Meanwhile, Medicare seeks to provide free and quality healthcare to the country’s elderly population, alongside a few other demographics.
Both of these programs are funded by the people’s Social Security and Medicare taxes. These taxes are paid for by both employees and their employers.
As for Social Security tax, the current withholding rate is at 12.4%. This is equally divided between employer and employee (6.2% apiece).
For Medicare tax, the current withholding rate is at 2.9%. This, too, is equally divided between employer and employee (1.45% apiece).
What these numbers show is that employers are legally mandated to share half of their employees’ Social Security and Medicare contributions. The only way to be exempt from this is by working with independent contractors.
Independent contractors file and remit their Social Security and Medicare taxes on their own. They do not get the privilege of receiving an employer’s “share” on these taxes.
Instead, what independent contractors get is relative freedom from the usual dictates of an employer. Independent contractors are able to exercise control over their trade, in terms of when, where, and how they want to do their job.
3. Unemployment Tax on Wages
The IRS requires employers to pay the Federal Unemployment Tax (FUTA), which goes to the federal government’s unemployment fund. This financial safety net aims to support workers who have been involuntarily released from their job.
Businesses ought to pay taxes amounting to a certain percentage of their employees’ salaries to supplement the federal government’s FUTA fund. Some states also impose this tax system, on top of that administered on the federal level.
Employers who have paid employee wages upwards of $1,500 within a quarter of a year, and have had at least one employed worker that rendered their services for at least 20 weeks, should pay unemployment tax on wages to the IRS. The current basic FUTA rate is 6% of each employee’s first $7,000 of earnings.
These earnings may cover any or all of the following:
- Wages and salaries
- Sick pay
- Vacation allowances
- Other non-cash benefits
This tax system excludes certain employee benefits. These exclusions include payments associated with the following:
- Meals and lodging
- Health benefits
- 401(k) account (employer’s contribution)
- Reimbursements of moving expenses
- Group term life insurance benefits
Working with independent contractors exempts businesses from paying unemployment tax on wages. Payments made by businesses to an IRS independent contractor are non-taxable.
4. Required Forms
The last major difference between an independent contractor and an employee with regards to tax treatment is the required information and forms that must be accomplished on the business’s end.
These are the information needed for an employee’s tax documents:
- Social Security number
- Tax filing status
- Number of exemptions
Meanwhile, independent contractor rules require these details:
- Taxpayer identification number
- Certification about backup withholding
For independent contractor fees exceeding $600, businesses must complete the 1099-MISC form and submit it to the IRS.
If your business relies on manpower, it’s crucial that you are knowledgeable about what differentiates an employee vs independent contractor, and what your tax obligations are for each. Otherwise, you might inadvertently commit tax filing errors that can jeopardize an otherwise good standing with the IRS.
We welcome questions and reactions in the comments section below.
If you owe back taxes, please visit taxreliefcenter.org for more information on tax relief options.