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Steve Windhaus Ask the Small Biz Adviser

Employee or contractor: What's the difference?

Dear Small Biz Adviser:
If I have four employees who will be working for about four months and they are all students making minimum wage, how would I go about paying them? Would I have to take out state and federal taxes? Or do I just give them a 1099?
Thank you.

Dear Stacey:
Yours is a classic case of knowing the difference between independent contractor or contract labor and employee status. Begin by reviewing the Internal Revenue Service FAQ page on employee-contract labor. More details are in IRS Publication 15-A, Employer's Supplemental Tax Guide.

In short, here are some of the guidelines:

  • A person generally is an independent contractor only if you (the payer) have the right to control or direct only the result of the work performed. The payer has no control over the means or the methods implemented to deliver those results.
  • Under common law there are four categories of independent contractors who will still be defined as employees under statutory law. They include drivers, insurance sales agents, individuals who work at home and full-time traveling or city salespersons. Details are on page 3 of Publication 15-A.
  • There are two categories of statutory nonemployees, including direct sellers and licensed real estate agents. View page 4 of Publication 15-A for the details.
  • Independent contractors are more likely to have unreimbursed expenses than employees.
  • The independent most often has substantial, if not complete investment, in the facilities he or she uses to conduct work.
  • Independent contractors generally are free to seek out business opportunities from employers in addition to you.
  • An employee is generally paid a wage or salary by the hour, day, week or other category of time. The independent contractor is usually paid a flat fee. Exceptions in some contractor professions include lawyers who can be paid by the hour.
  • An independent contractor can make a profit or loss.
  • The payer's control over when and where to work, tools used, what workers to hire or assist in the work, the order and sequence of work and which individual performs specific tasks are further evidence of employment.
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Again, read the publications I noted above for the full details. All conditions defined for contract labor must be met to avoid having to treat the individual as an employee. If so, the Form 1099 is issued. Review the IRS publication, Instructions for Form 1099-MISC, for more details.

Otherwise, employee status requires you to perform the following for the IRS:

  • Have each new employee fill out Form W-4, the Employees Withholding Allowance Certificate to determine exemptions and note the Social Security number.
  • Withhold Social Security, Medicare and income tax deductions for transmittal to the IRS via a tax account set up at your local bank.
  • Match Social Security and Medicare deductions for the employees.

Review the IRS publication, Wage and Tax Statement and Transmittal of Wage and Tax Statements, for the complete details.

It is quite obvious why many employers prefer to contract their labor needs instead of hiring employees. The cost of matching Social Security and Medicare deductions is eliminated. The paperwork process for a Form 1099 is so much simpler and less tedious than W-2s , W-4s and maintenance of the tax account.

I cannot advise you which direction to take. The nature of your business, the tasks the students will be given and the amount of control you need over the performance of their jobs will more likely influence your decision. Given that they will work for minimum wage will not be as burdensome on expense accounts, but the paperwork and bookkeeping cannot be avoided.

I wish you well with your decision.

-- Posted: July 19, 2001


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See Also

Business Tax Tip: passing the contractor-employee test

How to hire your first employee
Keeping a lid on salary costs
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