Payroll Processing FAQ: Employee or Independent Contractor?

Employee Classification for Payroll Processing

The first step is to classify your new hires, an important matter to the worker, employer, and associated government agencies.  When your business expands, there are several hiring options, each with certain payroll tax implications. This section will help you understand the choices available, as well as the costs and benefits associated with each classification.

For payroll accounting purposes, workers are generally classified as either employees or independent contractors. How a worker is classified will directly affect withholding and remittance of income and social security taxes, as well as how the earnings are reported to the government.

Who is an employee?

The Common Law Test can assist in determining if federal, state and local income taxes should be withheld from the worker and remitted to the appropriate taxing agency by the employer. The results of the Common Law Test will also determine if an employer must pay federal and state unemployment taxes on a worker’s earnings.

The Common Law Test focuses on four key points to determine if the worker is an employee:

  • Does the employer have the power to fire or terminate the worker at will?
  • Does the employer provide a place for the worker to work, such as a workbench in a shop or a desk in an office?
  • Does the employer provide the worker with tools, supplies, uniforms, or other items used on the job?
  • Does the employer have a voice and responsibility in what the worker does and how the worker does a job?

If all four questions can be answered “yes,” the worker should be classified as an employee. If there are any “no” responses to the questions, the worker should not be classified as an employee.

If a worker is classified as an employee, the employer must:

  • Withhold income and Social Security taxes from the workers pay.
  • Match the Social Security taxes each worker pays.
  • Pay federal and state unemployment taxes on each workers earnings.
  • Issue a Form W-2 to each worker after the end of each calendar year.

Who is an independent contractor?

A person that contracts to do work or perform a service for you or your business, while retaining total and free control over the means and methods used in doing the work or performing the service.

This worker is not subject to federal or state taxes, and as an employer you are not required to pay federal and state unemployment taxes on the workers wages.  This worker will require a Form 1099 after the end of each calendar year.