It’s time to define that relationship – Contractor vs. Employee (Part 1)

If you are in the category of entrepreneur or ‘solopreneur’, then, chances are, you’re juggling a variety of roles in your business and trying to be excellent at everything. At some point, you’ll need some assistance (maybe even a lot of assistance) to take care of all of the aspects of your business. So, what happens when you decide to bring someone else on to your team? Are they an independent contractor, or an employee? Does it matter what I label them as? What are the tax implications of each label? Well, I want to share with you some tips on what you can do when it’s time to define that relationship – Contractor vs. Employee. In the first part of this two part section, I’m going help you determine the proper definition for your relationship.

Why do definitions matter?

define employer vs. independent contractor

You may be wondering why definitions of this type matter. Consider this simple analogy. Jane is in a relationship with a man named Daniel. Daniel is Jane’s boyfriend. It’s April and the tax deadline is just a few weeks away. Jane files her taxes independently of her boyfriend Daniel, and spends her tax refund on a new sweater for her dog, Fluffypants. Daniel also receives a sizable tax refund, which he spends on an engagement ring for Jane. Nice! Fast forward one year, and Jane and Daniel are married. This tax season, they file a joint return, as getting married has tax implications. The moral of the story; the label of ‘boyfriend’ vs. ‘husband’ affected Jane’s tax filings. Hiring an ‘independent subcontractor’ vs. hiring an ‘employee’ has different tax implications as well. But how do you know which label is right for your relationship? We’ll get to that in just a second, but first, let’s talk tax.


How do you know which label is right for your relationship?
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What are the tax implications of your choice?

1099 or W2

Just like our analogy above, there are tax implications of how you label the relationship. When a service-provider is an independent subcontractor, you, the business owner, do not generally have to withhold or pay any taxes on payments made. However, if that service-provider is an ‘employee’, you will need to withhold income taxes, Social Security, Medicare, and pay unemployment tax on wages paid to them.

What does the IRS say about labeling the relationship?

IRS rules for employees and contractors

If you were seeking romantic-relationship advice, and asking “How do you know when it’s time to take it to the next level?” I might say something sweet (and cliché) like “You’ll just know in your heart what the right decision is.” That is NOT the advice I will give when advising about how will you know when it’s time to make the move from subcontractor to employee. Thankfully, our friends at the IRS are there to give us some relationship advice that is more pragmatic in these situations.

The IRS has a series of questions you can ask yourself to better define the relationship with your service-providers. Think of it like a relationship quiz in a grocery store magazine, just not quite as fun.

The primary criteria for defining the relationship is the degree of control and independence that exist in the performance of the service provided. The three essential areas to consider are:

  1. Behavioral – Does the business have the right to direct or control how the worker does the work? If the answer is yes, then you may be an employer. You may also be an employer if you have evaluation and training systems for the work performed.
  2. Financial – Does the business have the right to control economic aspects of the worker’s job? Consider if the worker needs to provide his or her own tools and supplies for the job. Also, evaluate whether the worker’s expenses are reimbursable or not. Finally, is the worker free to provide the same services to others in the market?
  3. Type of Relationship – How do the business and worker define their relationship? Do they have a written contract? Does the worker receive employee benefits such as insurance, vacation, sick pay, or a retirement plan? And finally, how long is the relationship? Is the service provided a key aspect of the business, or a support function?

It is important to note that no one factor is more important than others to determine the type of relationship that exists. You, business owner, must make a ‘reasonable determination’.

Do you still need help defining that relationship?

Determine my workers' tax status

If you’re unable to make a ‘reasonable determination’ based on the factors listed above, you may complete and submit an IRS Form SS-8 ‘Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding’. Seeing this process through to determine the best label may be most useful for a business that regularly hires the same types of workers, and needs clarity.

Closing

I’ve just shared with you some of the tips you can use if you’ve determined that it’s time to define that relationship – Contractor vs. Employee. In my next blog post about this topic, I will expand on this by sharing with you what you need to do once you’ve determined that it is in fact time to define, or even re-define that relationship. See you soon.

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