When there’s extra work that needs to get done and there are no sufficient employees to do the job, companies usually hire more workers to keep up with the customer rush. If you happen to find a job in a company, make it a point that you understand your status in that company. That way, you will know how you are supposed to be treated by your new employer.
More often than not, problems arise because independent contractors think of themselves as employees, and vice-versa. For some, knowing whether they are contractors or employees doesn’t matter because all that matters to them are that they got a job and an income. However, they don’t realize that not knowing which classification they belong to—independent contractor or employee—will put them at the risk of tax troubles in the future.
But how does the law classify contractors vs. employees?
Telling Between Contractors and Employees
On the surface, you probably cannot tell what sets contractors apart from employees because of most of the time, they do the same work. However, the law views them differently. The law also views the companies that hire them just as differently.
Basically, the thing that makes contractors different from employees is their degree of independence and control over the work that’s assigned to them. Usually, while an employee performs tasks that are dictated by others and are provided training to effectively do the job, an independent contractor has more than one client and sets his own hours at work. A contractor typically does not have a boss and he uses his own tools in performing his job. Also, his salary doesn’t automatically come at a definite date because he invoices for each of his completed assignments.
While that seems pretty much understandable, there can sometimes be gray areas, too.
In many cases, companies prefer hiring contractors instead of employees so they can save on labor costs. Financial-wise, hiring contractors makes more sense because contractors are not entitled to benefits. Also, companies save considerably on taxes since, in hiring contractors, it no longer becomes necessary for the employer to pay a portion of the state unemployment taxes.
Companies that follow the law and take the employee route usually regret their decisions at some point in the future because of the cost that making someone an employee entails. That explains why small businesses that operate on tighter margins are often tempted to hire contractors instead of employees, even when the job that needs to get done calls for an employee.
To minimize their costs, business owners make people believe that it is more advantageous to be a contractor than an employee since contractors’ take-home pays are bigger. While that may be true on the surface, that is not as simple as it seems.
The Tax Implications of Contractual Work
If you are an employee, your employer is the one that pays half of your Social Security and Medicare taxes and withholds half of these taxes from your salary. That and the withholding of your federal and state income taxes are the reasons why those employees who work at $9 per hour at fast-food restaurants take homeless every payday.
So, does that prove that being a contractor is better than being an employee?
The answer is not necessarily. Why? Because independent contractors pay 100% of all their Social Security and Medicare taxes when they file their tax returns and pay all the income taxes that were not withheld. And if you are a contractor and you failed to make estimated tax payments every quarter to cover your taxes, prepare yourself for an unfortunate surprise come April. This only goes to show how tax responsibilities affect the amount that employees take home during payday versus the amount taken home by contractors.
Contractors Escaping Taxes
Sounds common, doesn’t it? Many contractors believe that one of the advantages of being an independent contractor is that they get to escape taxes. Actually, they don’t. Well, that’s always possible. But that is not legal.
If you are a contractor and are paid in cash, don’t think that that already lets you get out of paying taxes and not report it. Whether your pay comes in the form of a check, cash, digital transfer or barter, and regardless of its amount, remember that every payment you get for each work that you do is taxable income.
Many contractors get all the more confused about taxable contract income because of the amounts that the IRS uses to require reporting of earnings. Remember that when you are a contractor, you get Form 1099-MISC to lay down the details of how much you have made for each job. Form 1099-MISC is what you need, not a W-2. However, as a contractor, an employer does not need to send you a form 1099 if your earnings during the tax year in question are less than $600.
The law can’t stress enough that the abovementioned rule is just a reporting requirement and has nothing to do with your taxable income. However much you earn, your earnings are always legally taxable and should be reported either on Schedule C or as other income on Form 1040.
For your FICA taxes, which refer to your Social Security and Medicare taxes, these taxes are self-employment taxes that you are responsible for in full. If you are an independent contractor, you should report the amount of your FICA taxes and pay them via Schedule SE.
While being an independent contractor has its share of advantages when it comes to taxes, there are instances when a business hires a contractor who is eventually deemed as an employee. In such cases, both parties lose a significant amount of taxes, interests, penalties, and premiums.
Since the relationship between a company and a worker sometimes tends to be a gray area, it is imperative that you protect your status as an independent contractor. Well, that is if you are really an independent contractor. To make sure that your work as a contractor remains independent of your employer, it should be able to pass the Four Point Test.
Determining Your Status
If one asks you now whether you are a contractor or an employee and what makes you think so, do you know how to answer?
In Canada, a four-point test helps workers to determine their relationship with the business that you are working for. The agency clearly sets out a method that lets taxpayers and workers identify the nature of their relationship with their companies.
The four-point test makes clear-cut distinctions between contractors and employees based on their control, tool ownership, risk of loss and integration.
- Here, the issue is who controls the worker. If the employer has all the right to hire or fire you, determine your salary, decide on the time and place of your work as well as the manner in which you should perform your work, then you are an employee. Even if the employer does not directly control how you do your job, if he still has the right to do so, then an employer-employee relationship exists between the two of you.
On the other hand, if you are a contractor, it is not necessarily the employer that runs the ship. As a contractor, you decide how you are going to perform your job and you maintain your right to decide where and when you are going to get the work done. In short, you are the only person responsible for planning the job that you need to get done.
- Ownership of Tools. When it comes to tool ownership, the common notion is that what sets contractors apart from employees is that contractors supply their own tools. While that may be true, the problem is that it is also customary for other employees to provide tools for themselves so they can perform their jobs, such as in the case of garage mechanics and painters.
If that is the case, then how does tool ownership differentiate a contractor from an employee? According to CRA, the cost of using the tools is a better indication of whether you are a contractor or an employee. As per the CRA rule, you are considered an independent contractor if you purchase or rent large tools that call for major investment and expensive maintenance. Otherwise, you are an employee. Another good example of a self-employed, independent contractor is a home-based IT worker who uses his own computer to perform his job.
- Chance of Profit/Risk of Loss. Here, determining which type of relationship exists between the business and the worker heavily depends on the financial involvement of the latter. Take a look at these questions:
- Do you have a chance of gaining profit?
- Are you at risk of incurring losses due to damage to materials, delays or bad debts?
- Do you cover the operating costs?
If your answer to all of these three questions is a Yes, then you are considered an independent contractor.
- This criterion seems to be an attempt to presume the intention of the involved parties. According to CRA, a business relationship exists if the worker integrates the payer’s activities to his own commercial activities. On the other hand, an employer-employee relationship exists if the worker integrates his activities to the commercial activities of the payer.
The CRA does not lay out how to determine such integrations. However, an obvious way of proving that you integrate your own commercial activities is by having multiple clients. If you have only one client, it becomes easy for others to presume that you share an employer-employee relationship with that client. But be careful when having a single client, because that puts you at risk of being declared as a personal services corporation by the CRA.
Deciding Whether to Become an Employee or a Contractor
Based on the facts discussed, it looks like being a contractor can be beneficial for you in terms of earnings and taxes, so long as you are prepared. However, remember that being an employee or a contractor is not really one of those decisions that you make when you look for a job. In reality, it is the business or company that decides whether you are a contractor or an employee.
Most of the time, employees are carried on the books, unlike contractors. So as a contractor, it is your responsibility to enshrine your relationship with the company you are working for through a contract. This contract should focus on the first three points of the four-point test and set out the intentions of both parties. Since you are an independent contractor, you have to make sure that such a written agreement is carefully crafted so your status is protected in case the other party subsequently changes his mind and argues that your relationship is not what you think it is.
At the end of the day, it is the business’ responsibility to weigh certain factors to determine whether a worker is an independent contractor or an employee. While other factors may indicate that one is an employee, other factors may indicate that he is an independent contractor. Apparently, there is no magic that stands alone in determining one’s status, but the key to making the right determination is by looking at the entire relationship that the person has with the company he is working for.
In a nutshell, what makes a worker an independent contractor is his being his own boss, although his work should still stay within the definitions of a contract with the party he is working for. Also, he is not eligible for benefits provided by the employer and retains a certain degree of independence and control. On the other hand, a worker is an employee if he treats the business as his stable source of income, is eligible for benefits and pensions, and gives up elements of control to his employer. He should also be working within the time and place specified by the employer.