Am I an Employee or an Independent Contractor for Tax Purposes?

More Americans than ever are choosing to take control of their professional careers and incomes. By doing so, they choose to be self-employed, independent contractors, or small business owners. While these new opportunities have created countless opportunities for growth and profit, they also come with new tax obligations.

Workers need to understand employment laws so that they can choose the correct worker classification for tax purposes. That way, they don’t risk running afoul of the Internal Revenue Service (IRS) when filing their return for a particular tax year.

What Is the Difference Between an Independent Contractor and an Employee?

An employee is someone who works part-time or full-time for a business. An independent contractor is someone who is hired by a business to provide a product or service. Employees are generally hired for an indefinite or extended period of time, while independent contractors are typically hired for a specific project or pre-determined time period.

“The penchant for employers who want to make a person an independent contractor is so they don’t have to pay payroll taxes. They don’t have to make Social Security or Medicare contributions for them,” explains Justin Burns, an employment litigation attorney for McMoran, O’Connor, Bramley & Burns P.C. in New Jersey.

An independent contractor could also work for themselves, such as a gig worker, be a partner in a trade or business, or be a sole proprietor.

How Do You Determine if You’re an Employee or an Independent Contractor?

Several legal tests are in place to help businesses and workers determine what type of employment relationship they have. These tests are crucial for ensuring that labor or tax laws are not violated. While the tests can vary, they all generally look at the relationship between the parties and the level of control that is exerted over the worker.

1. Getting an IRS Determination on the Employee Relationship

If a worker and their employer cannot agree on the employment classification, either party may file Form SS-8. This form formerly requested that the Internal Revenue Service (IRS) determine the employee relationship.

The IRS will consider several factors when making its determination. However, generally, the more direct control the employer has, the more likely the worker is an employee. A worker is more likely an employee when the employer can control what will be done and how. A worker is more likely an independent contractor if the employer only has control over the end product or result of the work but not how the worker will accomplish it.

2. Common Law Test for Determining the Employee Relationship

When common law governs the determination, the degree of control defines the relationship. This is separated into three categories: behavioral, financial, and type of relationship. An employee relationship is one where the employer can control how the worker does their work and what work they will do. How the worker is paid, expenses reimbursed, and supplies furnished will impact the determination.

Finally, factors that influence the relationship will be considered. This includes employee benefits provided or any written contracts signed between the parties. “In New Jersey, whether or not an employee in an individual is an employee or an independent contractor is based on the ABC test,” explains Burns.

3. Economic Realities Test Under the Fair Labor Standards Act (FLSA)

The Department of Labor (DOL) uses the economic realities test as defined in the Fair Labor Standards Act (FLSA). The latest version of the economic realities test took effect in March of 2024. Previously, the DOL would consider the totality-of-the-circumstances analysis when determining an employment relationship. However, this was often vague and open to interpretation. To resolve this, it has published a six-factor test:

1. Opportunity for profit or loss depending on managerial skill
2. Investments by the worker and the potential employer
3. Degree of permanence of the work relationship
4. Nature and degree of control
5. The extent to which the work performed is an integral part of the potential employer’s business
6. Skill and initiative

Tax Implications for Employees

Individuals who qualify as employees pay their portion of taxes from their paychecks. The employer calculates and withholds the appropriate amount of money when processing payroll, making it simpler for employees to file their federal income taxes. The business then pays its portion of payroll taxes and the employee’s portion on their behalf during tax season.

When first hired, the employer will have the new employee fill out a Form W-4. This lets employees choose the amount of their income tax withholding. While not guaranteed, the more withheld, the more likely the employee will receive a tax refund after filing their income taxes. When filing their yearly taxes, businesses will issue the employees a Form W-2. This form gives employees the information needed to complete their income taxes.

Under the Federal Insurance Contributions Act (FICA), employers pay a portion of the Social Security tax owed. The current tax rate for Social Security is 6.2 percent for the employer and 6.2 percent for the employee, or 12.4 percent total. The current rate for Medicare is 1.45 percent for the employer and 1.45 percent for the employee, or 2.9 percent total. Employers also pay into the Federal Unemployment Tax (FUTA). This federal program works with the state unemployment insurance programs to compensate workers who have lost their jobs.

Tax Implications for Independent Contractors

The IRS defines independent contractors, freelancers, and self-employed individuals fairly broadly. Even some individuals operating a small business may actually be independent contractors, depending on how they structured their venture. When filing federal and state income taxes, you must claim this income separately from employee income.

When a business hires a self-employed individual to work as an independent contractor, it should ask them to fill out a Form W-9. This form gives the business the worker’s Taxpayer Identification Number and Certification. That way, the business can properly claim business expenses on its taxes. Anyone who is paid over $600 in a single tax year must fill out a Form W-9. Prolific self-employed individuals may have to fill out several W-9s included in their tax returns for each of the companies that hire them.

Quarterly Tax Payments

Self-employed individuals are required to make estimated tax payments throughout the year. The IRS publishes the due dates for these quarterly payments. Don’t make these payments, and the IRS imposes a percentage penalty when yearly taxes are filed.

When it is time to file your annual federal income taxes, employers will send independent contractors a Form 1099-NEC. This form reports nonemployee compensation.

Self Employment Tax

Without an employer processing a paycheck, independent contractors are responsible for setting aside funds for tax payments. They are also responsible for the entire tax assessment.

In addition to paying income taxes, they must also pay self-employment taxes. This tax pays the Social Security and Medicare taxes that are normally withheld from the employee’s paycheck and partially paid by the employer. Independent contractors must pay 15.3 percent, which consists of two parts. There is 12.4 percent for social security taxes and 2.9 percent for Medicare taxes.

Potential Benefits

There are some potential benefits to being an independent contractor. First, they are not responsible for paying the FUTA unemployment taxes. There are also several credits and home office deductions available to offset the cost of working for yourself. These are not available to employees, as they do not bear the weight of these costs; the employer does.

Getting Tax Help

Deciphering which test applies or correctly determining employment status can be confusing. The more complicated the relationship, the harder it becomes to determine the correct employment status. Before filling out tax forms, taxpayers should consider speaking with an employment attorney. A lawyer will aid in deciphering the law to reduce the risk of misclassification.

Visit the Super Lawyers directory to begin your search for an experienced employment attorney. For more information on these legal issues, read our overviews on tax law and employment law.