One question we receive often is: What is the difference between being paid as Employee vs. Independent Contractor?
What are the pros and cons of each? Which way would I pay more tax? How do I best deduct my business expenses? These are the most common follow-up questions we hear. If you’re working as an Independent Contractor or an employee and may be considering making the switch, here’s the break down of what to expect from receiving income as employees vs. independent contractors.
The Determining Factor
Let’s look at how the IRS determines which classification you should be falling under. Which is important to know because many companies push this envelope to shift costs to the employee/contractor. You’ll want to be armed with this information, in case you are being paid in a manner that is not to your benefit. The determining factor when classifying an Independent Contractor vs. an Employee relationship, according to the Internal Revenue Service, is the amount of control invoked by the paying company.
An Independent Contractor is considered to be a person or business that provides a service to another individual or business, where the payer DOES NOT have the right to direct what will be done or how; but only the result of the work provided.
An Employee is someone working under an employer who DOES have the right to control how the details of the services are performed, not just the result of those services.
If the hiring company dictates when you work, requires you to request time off, pays you by the hour or a fixed salary rather than an agreed upon amount for a specific task, provides the necessary tools and space for the function, etc., then this is an employer/employee relationship.
Conversely, if the hiring firm will pay a specific dollar amount for a specific function while leaving the details of when and how it is done to the person being hired, then this qualifies for a contractor relationship.
Taxes – What You Should Know
One of the biggest tax differences between the two forms of payment is that the employer pays ? of the Medicare and Social Security taxes for an employee but a contractor pays this entire tax on their own.
Medicare and Social Security Taxes (FICA taxes) total 15.3% of the gross payment between the parties in either case. If you are an employee, you pay 7.65%, which the employer withholds from your wages, and the employer pays the other 7.65%. If you are a contractor, the company pays you 100% of your gross pay but you are responsible for payment of the full 15.3% tax when you file your personal income tax return. The result is that you pay 7.65% more in tax as a contractor than you would as an employee. You also bear the burden of submitting the tax rather than the employer doing it automatically.
This often results in a big tax surprise when a new independent contractor files their income tax return the first year.
Deductions & Record Keeping
As an Independent Contractor, you can deduct your resulting job expenses in a different way, which is usually much more beneficial. Employees and independent contractors can both allowed to deduct any ordinary and necessary expenses paid to produce their income. Whether it is deductible mileage, supplies, or home office expenses, each qualify for the deductions and have the same record keeping and substantiation rules.
The difference is in the limitations on deductions. Independent contractors can deduct these expenses directly against the income, without any limitations or potential pitfalls hurting the deductions. Rather than deducting expenses directly against the income, Employees deduct these costs as an itemized deduction on Schedule A, which subjects them to at least 3 major pitfalls:
- You must itemize your deductions to get any benefits. If you take the standard deduction because it is higher than your total itemized deductions, you’ll receive no tax benefit for these business expenses.
- The deductions are subject to the 2% rule. Basically, you only get to deduct these types of expenses that are in excess of 2% of your gross income. So, if you make $150,000 in gross income, you instantly lose $3,000 of your deductible expenses.
- This deduction is subject to the dreaded Alternative Minimum Tax (AMT). I’ll spare the long and boring details, but this means that if your income is high enough to subject you to the AMT. You could run the risk of not receiving any federal tax benefit for these business deductions no matter how high the amount you’ve spent ends up being. The income limit for AMT rules varies, but $200,000+ in income is a good rough number for when these rules apply.
Tax Planning Options
A final, and potentially major, benefit of being in independent contractor is the tax savings strategies that should be employed by doing some advanced planning. For example,
- Designing and implementing your own retirement plan
- Maximizing large deductions for vehicle or equipment purchases
- Variances in the way health insurance is deducted
- Options for setting up a separate entity for tax savings
So which classification is more beneficial to you? Unfortunately, as with many tax questions, the answer is that it varies from person to person. It’s relative to the specific circumstances in your situation – how much you’ll be paid, what amount and type of expenses you have, or how much non-business income and deductions you have, etc.
We’d be happy to discuss your situation in detail – contact our office for a tax planning consultation.