A common decision to be made for small businesses is whether to treat workers as employees or independent contractors. There are both legal and tax considerations for the treatment chosen. We will review the tax considerations for treating workers as independent contractors versus employees.
Most small businesses want to treat workers as independent contractors. It is less work for the business and less expensive to treat workers as independent contractors.
Employee or Independent Contractor
The basic difference is the business withholds and pays taxes on behalf of all workers treated as employees. The small business also has an obligation to pay employment taxes such as Social Security, Medicare and unemployment tax on wages paid to employees. In contrast, the business only pays independent contractors an agreed upon compensation. There are no taxes for the small business to withhold or pay for independent contractors.
Tax Forms Required for Independent Contractors
Generally, a small business hires an independent contractor under a contract with agreed upon terms such as scope of work, time period, and compensation. The small business has the worker fill out IRS Form W-9, Request for Taxpayer Identification Number and Certification. Form W-9 is used to gather the worker’s personal information: name, address, and Social Security number or Employer Identification Number (EIN). At the end the year, the small business will issue the worker IRS Form 1099-MISC, Miscellaneous Income. The amount reported on Form 1099-MISC is the exact amount of compensation paid to worker for the entire year. For example, you paid a worker treated as an independent contractor $5,000 for services throughout the year. At the end of the year, you will issue the worker Form 1099-MISC for $5,000.
Tax Forms Required for Employees
There are many more forms required when maintaining a staff of employees. As a result, it takes more time and effort for the business to manage payroll for employees compared to hiring independent contractors.
IRS Form I-9, Employee Eligibility Verification – Used to verify that the employee is legally eligible to work in the United States.
IRS Form W-4, Employee Withholding Allowance Certificate – This form is used to determine how much income tax to withhold from an employee’s wages.
State Form W-4 – If the state has an income tax then the small business is required to obtain State Form W-4 from all new hires. For the State of Michigan it is Form MI-W4, Employee’s Michigan Withholding Exemption Certificate.
IRS Form 941, Employer’s Quarterly Federal Tax Return, or IRS Form 944, Employer’s Annual Federal Tax Return – Both of these forms are used to report and pay employee withholding taxes and employer’s portion of Social Security and Medicare taxes. Depending on the filing requirements, the small business will either need to file Form 941 of Form 944. Form 941 is filed quarterly (every 3 months) and Form 944 is filed annually. All small businesses start out by filing Form 941. The IRS will notify the business if the filing requirements change to filing Form 944 annually.
State Withholding Forms – If the state has an income tax, there will be State withholding tax forms. The Michigan forms are Form 160, Sales, Use and Withholding Combined Tax and Form 165, Annual Return for Sales, Use and Withholding Taxes. Depending on the filing requirements of the business, Form 160 will need to be filed annually, quarterly, or monthly. Michigan Form 165 is filed annually.
IRS Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return – The FUTA tax is used to provide funds towards unemployment compensation. The small business is responsible for paying this tax.
State Unemployment Forms – Similar to the IRS, the small business may have to pay a tax used to provide funds towards unemployment compensation for the state. In the State of Michigan, the small business is responsible for filing Michigan Form UIA 1028, Employer’s Quarterly Wage/Tax Report and Michigan Form UIA 1017, Wage Detail Report. These forms can’t be downloaded. Both of these forms are provided to the small business by the Michigan Unemployment Agency.
Form W3, Transmittal of Wage and Tax Statements – The form is filled annually to the Social Security Administration. Form W-3 reports the total wages paid to employees and total taxes withheld from employees.
Form W-2, Wage and Tax Statement – For each employee, this form reports wages paid and taxes withheld. A copy of the form is provided to each employee and to the Social Security Administration.
It is more work and more expensive for the small business to treat workers as employees. This is only the tax implications of treating workers as employees. There are other aspects to consider such as maintaining an employee handbook, liability insurance, and workers compensation. Next we will discuss the costs differences for treating workers as independent contractors versus employees.
IRS Circular 230 Disclosure: To the extent this writing contains advice on a federal tax issue, the advice is not intended to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed in this communication.