Employee vs. Contractor: A Tax Distinction

Holidays can be especially joyous for someone who's looking for a job. Many companies, large and small, hire seasonal workers.

And while it's good to have extra income, make sure you understand how you're treated by your new, temporary employer.

If you are classified as an independent contractor instead of an employee, you could face some tax troubles at filing time.

Employee vs. contractor: What's the difference?

Although you might do essentially the same work, the Internal Revenue Service views contractors and employees -- and the businesses that hire them -- differently.

Determining whether the person providing service is an employee or an independent contractor is based primarily on the degree of control and independence over the work.

An employee typically performs duties dictated or controlled by others. In many cases, an employee is provided training to do the job. And an employee works for only one boss.

An independent contractor, on the other hand, generally has several clients. A contractor has his or her own tools (and in the modern workforce, this means digital devices, not just hammers and wrenches) and sets his or her own hours. And a contractor invoices for the completed work.

The distinction seems pretty clear-cut, right? It can be.

But it also offers businesses "a huge, with a capital G, gray area," says Judith E. Dacey, a CPA and principal of J.D. Sumter & Associates in Summerfield, Fla.

And some companies use some of the wiggle room to hire contractors instead of employees, in large part to save on labor costs. There's no need to pay benefits for contractors, and companies can also save on taxes because it's not necessary to pay the employer portion of Social Security and Medicare or state unemployment taxes.

In most cases, companies follow the law, says Sally Herigstad, a Kent, Wash.-based CPA and author of "Help! I Can't Pay My Bills." But it is, she says, a huge hassle to make someone an employee.

And that's why smaller businesses, already operating on tighter margins, might be tempted to go the contractor route even when the job calls for an employee.

"If you get a job at the local Christmas tree lot, they'll probably pay you as a contractor," says Dacey. "It also could be a small mom and pop restaurant that needs somebody extra to work on the side. Many small businesses don't want to do the paperwork."

Tax implications of contract work

And the business owner might tell you that being a contractor is to your advantage, too, pointing out that your take-home pay will be larger.

"If you get $9 an hour at McDonald's, you're not going to get the full $9 an hour," Dacey says of the pitch some employers make to entice potential contract workers. "But the worker at the Christmas lot gets the full $9 an hour."

At least, for a while.

When you're an employee, your boss pays half of your Social Security and Medicare taxes (together usually referred to as FICA taxes) and withholds your half of these taxes from your pay. That, along with withholding of income tax (both federal and state) is why the $9 an hour at the fast-food place comes to less each payday.

But as an independent contractor, you pay 100% of the FICA taxes when you file your tax return. You also must pay the income taxes that weren't withheld.

If you didn't make estimated tax payments each quarter to cover these taxes, you'll be in for an unhappy surprise in April.

"People normally like to think in terms of a refund, and you can't get refunded what you didn't pay anything in," says Dacey.

Herigstad says the tax responsibilities are a main reason for a contractor to get more pay than an employee -- typically 25% to 30% more.

All income is taxable

You might think that being an independent contractor will help you escape taxes.

That's possible, but it's not legal.

"If they pay you with cash, the green stuff, it doesn't get you out of paying taxes," says Herigstad. "I hear that all the time: 'I was paid in cash, so I don't have to report it.'"

It doesn't matter whether your payment is cash, check, digital transfer of funds or barter. It's taxable income regardless of the payment method or amount.

Additional confusion over taxable contract income also comes from the amounts the IRS uses to trigger reporting of the earnings.

When you're a contractor, instead of a W-2 you get a separate Form 1099-MISC detailing what you made for each individual job. The IRS gets copies, too.

But an employer does not have to send you, the independent contractor, a 1099 if you made less than $600 during the tax year.

That, however, is just a reporting requirement. It has no effect on your taxable income. Any amount you earn is legally taxable and you should report it, either on Schedule C or as other income on Form 1040.

"You may make just $10, but it's still taxable," says Herigstad. "What's right is right."

Then there is the self-employment tax, the FICA taxes you are responsible for in full. This amount is reported and paid via Schedule SE. But you don't owe SE taxes unless you netted more than $400 from all contracting jobs in a tax year.

Employee vs. contractor decisions

Being a contractor could be beneficial for you, from both an earnings standpoint and your taxes, as long as you're prepared.

But that's generally not your decision to make when you're looking for a job. The business gets to decide whether to carry you on the books as an employee or contractor.

The length of time you work -- for example, a few months over the holidays -- doesn't matter, says Herigstad. Neither does whether you're a part-time or full-time worker.

Again, it goes back to the degree of control over the work done.

And if the company improperly hires you as a contractor, it is the business that bears any compliance burdens and potential punishments. The IRS can come after the company when it discovers the misclassification and collect unpaid employment taxes, says Herigstad.

As for you, if you were paid as a contractor, you must deal with those tax consequences.

"It's perfectly fine to say, 'I want to be independently employed,'" says Dacey. "Just make an informed decision. Put some money aside because you will owe taxes. And April 15 is long after you've earned the money."

And there's nothing you can do then to change all the taxes you'll owe.