What are independent contractors?

An independent contractor is defined as an individual person or business that provides goods or services to another business or person under terms specified in a contract or short-term agreement.

Contractors are not considered employees, so the person or business hiring the contractor is not responsible for withholding taxes or providing benefits like health insurance and paid time off. This means that independent contractors are responsible for their own taxes and benefits, and they have more control over how they work and when they work. However, being an independent contractor can also have some drawbacks, such as not being eligible for unemployment benefits or workers’ compensation if they are injured on the job.

Businesses must classify each worker as either a salaried employee or an independent contractor based on the relationship that the business has with that worker. The key factor that determines whether the individual should be registered as an employee or an independent contractor is the hiring company’s level of control over the way that the worker performs their job.

How should businesses pay and report independent contractors’ income?

The main difference between employee income and independent contractor income is that employees are paid a regular wage or salary, and their taxes and benefits are typically withheld by the employer. Independent contractors, in contrast, are paid for the services they provide, and they are responsible for filing and paying their own taxes and contributing to their benefits. Thus, an independent contractor may have to pay a higher rate of tax than employees, because they are not entitled to the same tax breaks and deductions.

To report payments to independent contractors, businesses must issue a 1099 form to each contractor they paid throughout the year. The 1099 form shows the total amount of money paid to the contractor, and the contractor must report this income on their own tax return. The business is also required to report the payments made to the contractor to the IRS using a 1096 form. This form summarizes the total amount of money paid to all independent contractors during the year, and it must be filed by the business along with the 1099 forms.

What taxes independent contractors need to pay

Independent contractors bear the responsibility for paying their taxes by themselves, which include federal income tax, self-employment tax, and state and local taxes.

Federal income tax

Federal income tax is calculated according to the amount of money the contractor earns, and the rate varies depending on the amount of income and the contractor’s filing status. Independent contractors report their federal income tax on a tax return, which is a form that is used to calculate how much tax is owed.

The tax return includes information about the contractor’s income, deductions, and credits, and it is used to determine the amount of tax the contractor owes. The tax return must be submitted by the tax deadline, which is usually April 15 of each year.

Self-Employment tax

Self-employment tax is a tax that independent contractors are required to pay to fund programs like Medicare and Social Security. The tax is based on the contractor’s net income from self-employment, and the current rate is 15.3%. This tax is in addition to the contractor’s regular federal income tax, and it must be paid along with the contractor’s federal income tax on the contractor’s tax return.

The self-employment tax is important because it ensures that independent contractors and other self-employed individuals can access the same benefits as employees, such as retirement and health insurance.

Other taxes

In addition to federal income tax and self-employment tax, independent contractors may also be required to pay other taxes, depending on where they live and work:

• Sales tax is a tax on the sale of goods and services, and it is typically collected by the seller at the time of the sale. The rate of sales tax varies depending on the location of the sale, and the contractor may be required to collect sales tax on the goods or services they provide.
• State and local taxes vary depending on where the contractor lives and works, and they may include income tax, sales tax, and property tax. State and local income tax is a tax on the income earned by individuals and businesses, and it is typically based on a percentage of the contractor’s income.
• Excise taxes are taxes on specific goods or activities, such as gasoline or alcohol. Independent contractors might be required to pay excise taxes on the goods and services they provide, depending on their business. For example, a contractor who provides landscaping services may be required to pay an excise tax on the gasoline they use in their equipment.

What you should know about hiring an independent contractor

To classify independent contractors before hiring them, it is important to carefully inspect the terms of the working relationship and determine if the contractor will retain the right to control how they do the work. The penalties for misclassifying workers as independent contractors when they meet the criteria for employees can be significant. The penalties can include back taxes, fines, and interest, and they can be imposed on the business as well as the individual worker.

IRS classifications

The IRS uses three categories to classify all workers as salaried employees or independent contractors: behavioral and financial control, and the worker’s functional relationship with the company.

Behavioral control refers to how much the business can decide about how the worker performs their job. If the business has full control not only over what work is done, but also how it is done, then the worker is likely an employee. However, if the worker is at liberty to choose how the work is done, then it is reasonable to regard them as an independent contractor.

Financial control refers to the extent that the business can control the worker’s finances. If workers have the opportunity to reap profits or the risk of incurring losses based on their own decisions, then they are likely independent contractors.

The relationship (terms of engagement) between a worker and a hiring entity is another important factor in determining whether that worker is a contractor or employee. If the worker is registered as an employee for tax purposes, then the business bears the responsibility for withholding taxes and providing benefits like health insurance and paid leave.

The US Department of Labor’s classification

The DOL uses a similar set of criteria to the IRS to categorize workers as contractors or employees. These add to the criteria that the IRS uses to classify workers as employees or contractors – the Department of Labor (DOL) also considers other factors to determine that a worker should be treated as an independent contractor.

These factors include the degree of expertise or skill required for the job, the permanency of the work relationship, and the worker’s level of integration into the hiring company.

State classification

State labor departments may also consider other factors when defining someone as an independent contractor. These factors may include the worker’s integration into the overall business, which the person’s services are critical to the business, and whether the person had to invest in the equipment and tools needed to perform the job.

Many states use the ABC test to determine if someone is a contractor or employee. The test is based on three factors: the worker’s ability to control how they work, the type of work performed, and the worker’s relationship with the business.

To be considered a contractor, the worker must be involved in an active independent occupation, trade, or business. This means that the worker must be providing services to multiple clients, and they must have a business relationship with the business.

Conclusion

In conclusion, companies that hire independent contractors need to be aware of their tax obligations. Independent contractors are responsible for their own taxes, which include federal income tax, self-employment tax, and state and local taxes. Companies are required to report and pay taxes on income received by their independent contractors, and they must issue a 1099 form to each contractor they paid during the year.

Misclassifying employees as independent contractors can result in significant penalties for the company, so it is important to carefully classify workers to avoid these penalties and other negative consequences.