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Independent Contractor or Full Time Employee? Bookkeeping Tips and Strategies

October 23, 2013 by Ed Becker

Contractor of Full Time?

In terms of bookkeeping, the difference between full time employees and independent contractors is essential knowledge for small business owners. Incorrectly classifying your workforce could lead IRS penalties, costly lawsuits, or both.

How to Classify an Independent Contractor

The primary identifying feature of independent contractors is their ability to control the method in which work is performed. For example, when you hire an independent contractor to paint your office building, you only have control over the end result of the job. You are not able to directly control the hours worked, equipment used, how they hold the paintbrush, etc. In contrast, a full time employee generally is given well-defined guidelines and performance measures about how to conduct their work. If you hire a full time employee to paint your office building, you will have the ability to control virtually any aspect of how the work is performed.

It is also necessary to classify workers based on the nature of their work as it relates to your business. In general, it is not permissible to hire contract workers that perform identical duties to that of your company. If you own a house painting business, you would not be able to hire independent contractors to paint houses. Unscrupulous businesses commonly use this tactic to avoid paying overtime and payroll taxes, thus making the practice illegal.

Tax Forms and Withholding Requirements

If you use a service like QuickBooks Payroll, tax withholdings for full time employees should be a cinch. QuickBooks has implemented a number of safeguards to ensure that your full time employees have state and federal taxes withheld at the appropriate levels. All you need to do is report the hours worked, and the software will take care of the rest.

Managing payments and tax reporting for independent contractors can be a little trickier. When a contractor receives more then $600 in payments during the tax year, they must be supplied with the 1099-MISC Miscellaneous Income form. This form will report the total income the contractor received from your company during the year. Failing to provide this form is a common mistake identified in IRS audits, which can lead to penalties of up to 35% and a disallowance of any deductions. The contractor is required to pay self-employment taxes, which is far less likely to happen if the employer does not provide a 1099. The IRS is likely to extend their audit to the contractor if a 1099 was not provided. Ultimately, this situation will end on a sour note for both the employer and the independent contractor.

Tips for Better Bookkeeping

It can be tempting to hire an independent contractor over a full time employee – no overtime pay, no health insurance benefits, no need for office equipment, and greater flexibility. However, failing to properly classify an independent contractor can lead to devastating consequences for a small business. There is a long list of companies that have been sued by former employees claiming that they were incorrectly classified as independent contractors. Successful plaintiffs can seek compensation for back wages, legal fees, and related damages. Smart business owners must ensure that independent contractors are fully eligible to be classified as such. Take a conservative approach when hiring contract workers to eliminate the chance of wage and hour lawsuits in the future.

Lastly, rely on the experts to handle payroll for full time employees. The most costly accounting mistakes are often related payroll errors. Having a professional accountant handle tax withholdings and worker classification will greatly reduce your risk exposure to bookkeeping errors.

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