Employee vs. Contractor: How Does Employee Status Affect Payroll?

Whether you have a service provider or do your own payroll, it’s important to understand employee status so you have the correct classifications for taxes. Before you can pay a worker for their services, you need to know your responsibilities as the employer.

There are two main types of status – employed and self-employed (or contractors). The IRS sees each employee status differently, and that applies to tax obligations and payroll management.

The Difference Between Employee and Contractor

As determined by the IRS and state tax agencies, the difference between employee and contractor is based on the amount of control the company has over the worker. Company employees work for one boss and their duties are determined by that boss. If you, as the employer, have control over how the person works, what is produced and where and when the work is done, the proper classification is generally employee.

When a worker is considered a contractor, that generally means he or she may have multiple clients, works on their own schedule and provides an invoice for work once it’s completed. Contractors don’t receive benefits and are responsible for paying their own payroll taxes.

Tax Rules for Different Employee Statuses

All income is taxable, but businesses aren’t responsible for the payroll taxes when the person providing the service to the company is on contract. Independent contractors are required to pay all Social Security and Medicare taxes, as well as any federal and state income taxes, even though they aren’t withheld on each paycheck. Contractors are supposed to receive a 1099 form from the employer unless they made less than $600 that particular tax year. When the contractor fills out the 1099 form, a copy is sent to the IRS, so even though the employer isn’t reporting income for the contractor, it is still taxable.

Employees, on the other hand, get income taxes withheld from each paycheck. They also have half of their Social Security and Medicare taxes withheld, while the employer pays the other half. As an employer, you have to withhold these taxes and pay your half, as well as unemployment tax, for each worker with employee status.

Why Employee Status is Important to Employers

Knowing what you are responsible for as an employer is critical if you don’t want to get in trouble with the IRS. Misclassifying an employee can lead to penalties and you will most likely have to pay the employee taxes anyway once the IRS looks into it. To avoid any issues, make sure you properly classify all workers based on the guidelines set by the IRS and state tax agencies.