Many business owners don’t realize this but the classification of your workers is very important. It will impact your tax obligations, who owns their work product, and more.
This is Part 2 (Tax Responsibilities) of a four part series on hiring employees and contractors. You can learn more in Part 1 (The Differences), Part 3 (Intellectual Property Issues), and Part 4 (Other Considerations).
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To keep things simple, you should just know that the IRS (and in many cases, state and local governments) will collect a portion of wages paid to someone in exchange for their services to cover income taxes and employment taxes (medicare and social security).
With employees, the employee will pay some of those taxes and the employer will pay some of those taxes.
With contractors, the contractor will pay all of those taxes.
When you hire an employee, your business must (a) withhold portions of their wages (for the employee’s income taxes and their share of their employment taxes); (b) remit those withholdings to the government on a regular basis; and (c) pay your share of the employee’s employment taxes to the government. In some situations you’ll also have to pay into workers’ compensation funds and pay additional unemployment taxes.
Due to the withholding and other requirements, it is usually best to use a payroll provider or cloud-based platform to help you manage the process. We use gusto.com and really like the platform (FYI – that’s our referral link).
In total, you should anticipate paying 10%-12% more in taxes and similar expenses when hiring employees as compared to contractors.
Things are quite a bit easier when you are paying a contractor for services because the contractor is responsible for withholding and paying all of their taxes. Further, you can usually avoid workers’ compensation and unemployment tax obligations with respect to contractors.
However, if you pay a contractor who is taxed as a pass-through entity more than $600 in one year, then you need to use W9s and 1099s for that contractor:
- Background: Since you don’t have to do withholdings when you pay a contractor, it’s entirely possible that the contractor could hide the payment from the IRS. That’s why we have W9s and 1099s.
- IRS Form W9: Always ask your contractors to give you a W9. It’s a simple form that the contractor will use to give you their legal name, address, SSN/EIN, etc.
- IRS Form 1099: With the W9 in hand, you can then complete a 1099 at the end of the year. You’ll enter in the contractor’s information and how much you paid them and you’ll give a copy to the IRS (and another copy to the contractor). The IRS will then use that information to make sure the contractor reports the payment on their tax return.
Also note – if you operate as a pass-through entity, then you’ll have to give a W9 to any client which pays you more than $600 in a year.
*This article is very general in nature and does not constitute legal advice.