The way we work is rapidly changing, but the tax and legal status haven't. Generally, you're either an employee or an independent contractor. Let's go over the differences between an independent contractor status and an employee. This status can have a significant impact on your tax liability.
The IRS and other government agencies generally use the "right of control" test to see if you're an employee or independent contractor. These boil down to three major things:
Is somebody giving you instructions on how, exactly, to do the job? You're likely not an independent contractor. Basically, a company hires an independent contractor to do a job but doesn't tell them how to do it. Additionally, self-employed workers often provide their training.
Of course, the person or company will have some financial control because they're paying you. But, this aspect centers around you receiving compensation by the job. It also includes the opportunity for a profit or a loss.
As an independent contractor, you're required to provide your equipment and pay for your business and travel expenses. You can bill or bake the price of these expenses into what you charge your client. But the opportunity for a profit or loss on the job is crucial.
Do you and the company hiring believe you are an employee or self-employed? For example, you'll typically have signed a client agreement. You also won't receive employee benefits like health insurance. You should also be performing services that aren't a part of the company's "regular business activities."
Let's go over how the "right of control" tests apply to workers who have employee status. If these apply to you, you're likely an employee or perhaps should be labeled as such.
As an employee, you receive instructions about how to do your work and often, must follow those instructions. You also could receive training from the company that hires you.
Businesses reimburse employees for their business or travel expenses. They also can use facilities and equipment provided by the hiring firm free of charge. Companies pay employees by the hour or unit of time, not on a per-job basis. Keep in mind that independent contractors can also charge per hour.
Also, employees shouldn't have the opportunity for a profit or loss for their work.
One of the biggest indicators that you're an employee is receiving benefits. This could include health insurance, commuting reimbursement, retirement benefits and more. Also, employees are performing services that are part of the hiring party's core business.
Again, these are guidelines to determine whether you're an independent contractor or an employee. Many businesses prefer to hire independent contractors because it can be cheaper in the short term. Keep in mind, improper classification of employees can lead to lawsuits and penalties.
The difference between being an employee and being an independent contractor can have a major impact on your taxes. It can also impact what deductions you can take to lower your tax bill.
As an independent contractor, your wages won't have any taxes withheld for health insurance, Medicare or Social Security. You'll still have to pay this through the Self-Employment Tax. Do this through quarterly tax payments. Don't forget to file your yearly tax return, too.
Independent contractors can also claim valuable deductions that often don't apply or aren't as relevant to employees. This includes the mileage deduction, deducting the costs of starting up a business, health insurance premium deductions and more.
Work-related deductions for employees have more limitations. But, you still have options. For example, you can take a mileage deduction if you use a personal car for work and reimbursed less than the standard mileage rate.
Note: You can also be a statutory employee or a statutory nonemployee. These account for a relatively small number of the workforce, so we'll skip over these for now.