Independent Contractors: A Definition and Some Tax Insight

I’m excited to write about a subject that I come across far too often – the independent contractor status and the tax impact of being one.

Many people may associate the term independent contractor with that of someone who works on a house (think of a plumber, an electrician, or handyman). Although these individuals may fall into this category, the reality is that anyone can be an independent contractor. The IRS has pretty clear guidance on how to determine if an individual is an independent contractor. Simply stated, an individual is considered an independent contractor if the payer has the right to control or direct only the result of the work, and not what will be done, or how it will be done.

What does this mean?

Well, let’s use an example. Let’s say I hire someone to help me with my social media. She is hired with the understanding that she has full access to my social media accounts using her own devices (computer, smartphone, or tablet) and all that I have explained to her is that I want her to respond to questions and actively market my firm. How, when, and from where (geographically) she does this is up to her. We establish some rules such as no profanity or bias, but other than the rules we set, it’s all within her control. She gives me daily reports of her work but that’s about it. She’s likely considered an independent contractor for tax purposes. I control only the results of her efforts (responding to questions and actively marketing my firm), but how she does it or by what means is out of my hands. Of course, if I don’t like how she does her job I can always terminate our agreement.

What about employees?

But what if we changed a few things. Instead of working with her own devices she instead agrees to meet me at my office a few hours per week and uses my firm’s computers to access my social media accounts. She can only do her work from my office, no remote access is allowed. In addition, I establish a standard set of guidelines for marketing my firm including how, when, and about what to post. I give her the exact words I want used on my social media accounts. She’s really only there to go through the process of posting on my accounts. Since she’s at my office though, I also have her answer the phone, prepare client deliverables, and even reply to my e-mail. She’s working under my direction, having been told what to do, and how to perform tasks. She is now more likely considered an employee for tax purposes.

Why is this a big deal?

The tax difference between an employee and an independent contractor could be significant. At the time of this writing, employers are responsible for 50% of the FICA tax which is 7.65% (Social Security tax of 6.2% plus Medicare tax of 1.45%) on each employee's first $118,500 of salary and wages. The employee covers the other half. You may never even notice this if you receive a steady paycheck because it’s all taken care of through the payroll processor.

On the other hand, if you’re an independent contractor, you’re on the hook for the whole amount of 15.3% (Social Security tax of 12.4% plus Medicare tax of 2.9%). It may not sound like much but on $10,000 in earnings one would owe $1,530 just in Social Security & Medicare taxes, not to mention the federal and state (if applicable) income taxes to be paid. The payer has no responsibility to assist independent contractors with withholding. What’s worse is that inexperienced individuals who are considered independent contractors don’t know they have been classified as one until they receive a 1099-MISC at tax time. By then it’s too late to file estimated taxes on the income and the taxpayer receives a crushing year-end tax bill that they may not be prepared for. Luckily you can write-off expenses against income earned as an independent contractor, but there are rules and limitations around that too and poor planning may mean lost deductions or hours of work to recreate expense statements.

Ask questions.

Whenever you agree to work for someone you should always ask if the position is contract or employment. Some telltale signs are if you are asked to complete a W-4 or a W-9. A W-4 is typically requested for employees and a W-9 for independent contractors. Your social security number is required for your employer to file the necessary forms for tax reporting purposes. Don’t provide any information or sign anything until you understand the consequences of what you’re getting into. If you are signing on as an independent contractor, it’s best to begin the habit of paying estimated income taxes. Check back soon for a post on filing estimated income taxes.

Confused? Have an opinion? Leave a comment below or give me a call.