Converting an independent contractor to an employee involves several steps, and when doing so it’s important to comply with relevant labor laws and regulations. This is a general guide so keep in mind that rules may vary depending on your location and industry. It’s always advisable to consult with legal and HR professionals to ensure compliance.
Independent Contractor vs. Employee – What’s the Difference?
People often are confused with what actually is an independent contractor and what is an employee. The employment status of the work that you do has far reaching effects for tax purposes.
An employee pays payroll taxes through withholdings which includes Social Security tax and Medicare tax. Social Security tax is 12.4% of earnings while Medicare tax is 2.9%. Employees pay half of each tax while their employer pays the other half. Independent contractors don’t have that luxury. They pay the entire 15.3%.
NOTE: Social Security tax is paid up to a certain maximum. The maximum amount is called the Social Security wage base and changes every year.
Let’s take a look at an example of how converting independent contractors to employees can result in different tax obligations.
Leslie is a software engineer and is paid $100,000 per year as an employee. Her company has offered her the opportunity to work as an independent contractor. Leslie pays $7,650 in payroll tax current ($100,000 x 7.65%) but will pay $15,3000 ($100,000 x 15.3%) as an independent contractor. Without regard to employee benefits she’d give up such as health insurance, vacation pay and sick time, Leslie would have to at least increase her compensation by the additional tax that she now would have to pay as an independent contractor.
Benefits of Hiring Independent Contractor
From a business owner’s perspective hiring an independent contractor instead of an employee can have clear financial benefits. In addition to having the independent contractor pay their own taxes, the business owner does not have to worry about overtime pay, unemployment or workers compensation insurance.
Health insurance is also another benefit that many full-time employees expect to receive. However, the cost of healthcare premiums is a significant burden particularly for small business owners. Health insurance coverage seems to increase every year and that trend is expected to continue.
Hiring employees can be costly. Interviewing and training are also time consuming. A business owner can avoid these added responsibilities and still save money by hiring an independent contractor.
Another benefit to hiring an independent contractor is the access to someone with top talent. A small business owner may not be able to afford such a person as a full-time employee. Also, many consultants are self-employed individuals who prefer the flexibility of contract work.
Paying an Independent Contractor
Paying an independent contractor is slightly different from paying an employee. The business is usually not required to withhold tax from payments made independent contractors. Instead the business requests that independent contractors complete Form W-9. The business should retain this document and provide the independent contractor with Form 1099 if at least $600 in payments were made during the year.
The business is responsible for providing the independent contractor with Form 1099 by January 31 showing their earnings for the previous year.
Benefits of Hiring Employees
At first glance it may seem as though there is little incentive to hiring employees but there can be some positives. When you bring on employees it is with the intent of them staying long-term. Successful businesses are built on solid teams. You are able to develop systems and a company culture that would be less likely to do with contractors.
Employees can make a break a business. For many businesses low turnover and loyal employees IS their competitive advantage.
Paying an Employee
If you hire an employee there are formalities that you must take. Once someone becomes an employee, whether full time or part time, you as the employer will need to run company payroll. The new employee must complete at least the following forms:
These forms, along with copies of any photo IDs or other legal documents, need to be completed by the new employee and kept in a permanent file.
The employer is responsible for withholding and transferring the taxes to the IRS and other tax departments. Employees should receive Form W-2 by January 31 showing their earnings for the previous year.
How to Determine Who is an Employee
Many small business owners will pay workers as an independent contractors as employees. It may seem like a good way to avoid having to pay tax and all the administrative responsibilities that goes with that. However, it’s a bad idea to pay someone as an independent contractor when they are really an employee.
The Internal Revenue Service (IRS) has certain guidelines to determine if someone is an employee and they examine the following:
- Behavioral Control
- Financial Control
- Relationship
Behavioral control looks at how much say the business has on the work that the hired person does and how they do it. Do you determine where the work is done and how it’s done? Do you provide tools and uniforms for the person to do the job?
Financial control looks at monetary investment that the hired person has in the job. An independent contractor is more likely to obtain their own insurance, provide their own tools and general have more of an investment or profit incentive in the job.
Is there a bona fide business relationship between the parties? Is there an employment contract in place spelling out the terms of the work?
All of these are factors that the IRS will use to determine if the person you hired is an independent contractor or an employee.
Misclassified Workers
The government takes payroll taxes seriously. It’s a good chunk of their budget. In fact, payroll taxes make up almost 1/3 of federal revenue. If an employer treats workers as independent contractors and does not pay the necessary payroll taxes the IRS can reclassify those earnings as salaries and then attempt to collect the back taxes along with penalties and interest.
What happens though if you paid someone as an independent contractor but realize that they are truly an employee? It’s not too late to convert independent contractors to employees. The IRS has the Voluntary Classification Settlement Program which allows you to essentially come clean. You have to make the request to the IRS. If you are accepted you agree to convert your contractors to employees moving forward and comply with all payroll tax filing and payment requirements.
In order to qualify for the Voluntary Classification Settlement Program you must not currently be under audit and you must have filed tax forms timely over the past 3 years for the workers that you treated as independent contractors.
If you can get over those hurdles the IRS will allow you to pay only 10% of what would have been otherwise due for the most recent tax year, not assess any penalties or interest and agree not to perform a payroll tax audit for the misclassified period. Not too shabby!
Calculate the Total Cost of Hiring an Employee
Before you convert independent contractors to employees be smart. Develop a budget. Calculate the total cost of not only their salaries but the other employment costs such as benefits. An employer must pay workers compensation and unemployment along with the employer’s half of payroll taxes.
Take into account the additional benefits you will need in order to attract and retail quality staff. In a competitive labor market as we’ve seen in recent years, qualified employees not only desire these perks they demand them.
If you have been paying your workers as employees it might be a good time to look into the VCSP if you may have misclassification risks. A good workforce is the backbone of any thriving business. Make sure that yours are paid correctly and you are on the right side of the IRS.
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