Employee Vs. Independent Contractor Tax Issues
There are many issues surrounding the classification dynamic of labeling a worker an employee or independent contractor. Employees are at-will workers for a business and have taxes withheld from their paychecks, as well as Social Security, FICA and Medicaid. Independent contractors, meanwhile, are self-employed and must file their own taxes, paying estimated quarterly payments during the year.
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Classification
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According to the Internal Revenue Service, there are three basic components to classifying a worker as an employee or independent contractor: behavioral, financial and relationship type. Specifically, does the worker set her own schedule and have control over the work? Does the worker get paid regularly by the hour, week or month, and is he reimbursed expenses? Where is the business conducted, and is the relationship ongoing? While there is no exact definition on what constitutes an employee, in 1987 the IRS developed a 20-factor test to help classify.
Compensation
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As a rule of thumb, employees are paid for time worked whereas independent contractors are paid for services performed. According to LegalZoom, a popular self-help resource, workers that are paid by the hour, week or month are more likely to be considered employees by the IRS. On the contrary, independent contractors are more likely paid a flat fee by project, or if they are paid hourly, it is either an inconsistent or small portion of their income. Misclassification of an independent contractor by an employer could result in penalties and payment of back employment taxes.
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Worker Rights
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Employees have certain additional employment rights that are not afforded to self-employed individuals by the Fair Labor Standards Act. The FLSA establishes wage, overtime, age and labor protection for federal, state and local employees. Specifically, affected employees must be paid at least federal minimum wage ($7.25 per hour as of July 24, 2009), must receive time and a half for working more than 40 hours in a week and must be paid for all time worked. In addition to the FLSA, state laws sometimes govern how often employees must be paid.
Termination
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When a relationship is severed between an employee and her employer, laws govern how soon the employee must be paid a final paycheck, whether unemployment compensation can be collected and, in some cases, whether a termination is justified. However, for independent contractors there is no such protection, and any pay disputes must be settled in civil court. Independent contractor agreements, often used between an employer and a subcontractor, sometimes stipulate the length and scope of such a relationship--giving an independent contractor added protection.
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References
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