Do you know the difference between a contractor and an employee? Knowing the difference could save you a hefty IRS penalty fee. Small business owners who often use contractors need to know the difference between what the IRS deems an employee versus an independent contractor. Employers must pay federal employment taxes, including the employer portion of Social Security taxes and federal unemployment tax. along with workers’ compensation/disability premiums.

As CBS’ Money Watch reporter Ray Martin writes,

So, if you run a small business and hire workers, you’ll definitely want to be clear as to whether these workers are independent contractors or employees. For federal tax purposes, this really matters. It affects how and what taxes you pay and how you file your tax returns.

When you pay a person as an employee, you’re responsible for paying additional taxes. They can amount to an additional 8 percent or more on top of what you pay the worker. In the case above, the additional cost was over $2,400 annually for each worker that the IRS determines is an employee rather than an independent contractor.

Do you know whether workers are contractors or employees? The IRS and tax courts determine this into three categories: behavioral, financial, and relationship. The main factor in determining the distinction is based on the method of compensation: is the worker on payroll and a recurring paycheck? Then they’re deemed an employee by the IRS.

To learn more about how you can distinguish between a worker and and employee, click below for more of Martin’s sage tips.

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