For freelancers and others working in the gig economy, whether they are an employee or independent contractor has important implications. Workers of either classification need to be aware of the pertinent issues that may impact their finances and taxes.
Which classification applies to me?
Whether you should be classified as an employee or independent contractor is not as straightforward as you might imagine. According to IRS guidelines, the primary factor is how much of a right the “employer” has to exercise control over the worker’s activities. If you must perform your job at a certain time and place and in a certain way, you are probably an employee. On the other hand, if you are largely left to your own devices to simply produce a deliverable by a deadline, you are probably an independent contractor.
The other two factors are financial and relationship. Financial considerations include whether you are responsible for your own expenses or providing your own tools. If this responsibility falls primarily on you—for example, if you bear the risk of incurring a loss—then you are probably an independent contractor. Finally, the relationship factor examines what sorts of formal arrangements exist, if any.
The IRS explains that there is no “magic” formula or bright-line rule. In other words, the determination is based on a totality of the circumstances. In cases where employment seems to fall somewhere in the middle, or has qualities that match factors of both an employee or contractor, consider the whole to try to determine whether the position aligns more closely to the employee or contractor definition.
What are the implications?
If you are an employee, you should have taxes withheld from your paychecks and receive a W-2 in January. You will also have various employee safeguards depending on your state, including workers compensation for job-related injuries, protections against unlawful discharge, and the right to receive overtime pay if you are an hourly employee. However, you cannot deduct unreimbursed employee expenses such as business use of home, mileage, or cell phone usage when you file your taxes (except in certain rare circumstances).
If you are an independent contractor, you are considered self-employed. You are responsible for all your own taxes and other expenses, and you should receive a 1099 in January showing the total amount paid the year prior. (You must report your income even if a 1099 never arrives.) Labor laws providing protections for workers generally do not apply. You do, however, have much greater control over your day-to-day work and can deduct any expenses incurred in performing that work.
Many folks do not realize (and there is no reason for them to!) that when their employer withholds Social Security and Medicare taxes from employee paychecks, the employer also has to match those amounts. When you are self-employed, including as an independent contractor, you wear both the employee and the employer hats, so you are responsible for both sides of the equation.
The United States has a “pay-as-you-go” taxing system. You will be charged penalties if you owe enough and wait until the end of the year to fulfill your tax burden. Reach out to me for help to set up regular tax payments and avoid these penalties. Employees do not need to worry about this if they have sufficient taxes withheld from their paychecks because employers are responsible for paying these throughout the year.
Employers who misclassify their workers as independent contractors can be held liable for all past employment taxes, withholding taxes, and penalties. Additionally, owners and other “responsible persons” of business entities can be held personally liable for failure to transmit employment and withholding taxes.
Which is better?
You might someday be in the position to effectively choose whether you will be an employee or independent contractor based on how you set up a working relationship. All else being equal, whether being an employee or independent contractor is better is largely a matter of personal preference. Because of the various implications that each status entails, though, it is hardly equal.
For example, assume you are paid $40/hour and work 25 hours in a week. Your gross amount earned is $1,000 for that week. If you are an employee, your paycheck might be $758.50:
If you are self-employed, you will simply be paid $1,000.00. So much better, right?! Not so fast. You will still owe the federal and state income taxes, Social Security, and Medicare. You will also owe employer contributions to Social Security and Medicare, so tack on an additional $62.00 and $14.50, respectively. Further, you will be responsible for actually paying these amounts over to the federal and state tax agencies. Do not make the mistake of treating that entire $1,000.00 check as available cash!
Because of the extra costs involved, I typically recommend that folks negotiate at least 10% in additional compensation if they will be independent contractors versus employees. In other words, you must earn $44/hour as an independent contractor to make the same amount as an employee being paid $40/hour.
Social Security is 6.2% of gross wages, and Medicare is another 1.45%. Plus, you will likely need professional assistance regarding self-employment that you would not need otherwise.
Folks who are ineligible to work in the United States cannot be employees, but they can still work as independent contractors. Contact me for help if this applies to you!
What if I am misclassified?
Because of all the extra costs and bureaucratic hoops involved with having employees—workers compensation, overtime, federal and state unemployment taxes, employer contributions to Social Security and Medicare, and the mechanics of actually handling these costs—businesses often prefer to classify workers as independent contractors. On the flip side, workers often prefer to be employees for similar reasons.
However, a business cannot simply deem its workers to be independent contractors because that is its preference. If the factors demonstrate that an employment relationship exists (rather than a contractor relationship), you are an employee regardless of the label that might be applied. The first step is to attempt to straighten out the issue with your employer. An administrative snafu can be corrected easily at the beginning, but it gets harder to unwind later on.
If your employer is resistant, reach out to your state labor department. They can assist you in updating your working relationship to the proper classification and making sure you get the proper protections afforded by law.
Now what?
Whether you are an employee or an independent contractor depends largely on which party has the right to control what you do, and how and when you do it. There are benefits and drawbacks to each, so make sure you are classified properly. If you are an independent contractor, demand extra compensation to offset the extra costs. If you get to choose, select whichever option makes the most sense for you.
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