Improperly classifying workers is one of the biggest mistakes a business owner can make. Why? Because the IRS is very serious about employee classification and will enforce penalties if you are in error. Although the IRS breaks workers down into four specific categories, the most important decision is weather to consider an employee an independent contractor or a wage-earning employee.

If your worker is an employee then you must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment taxes on their wages. You do not generally have to withhold or pay any taxes on payments to independent contractors. However, if you incorrectly classify an employee as an independent contractor you can still be held liable for employment taxes.

What is the difference between independent contractor and wage earning employee?

As general rule some one is an independent contractor if the employer controls only the result of the work, not the means or method of the effort. While with wage earning employees the employer controls exactly what tasks will be completed and how they will be done. In more basic terms, if you give a task to some one, and pay them a set amount for the project without monitoring their efforts then they are an independent contractor. On the other hand, if you hire some one to use your equipment, follow your instructions, and pay them by the hour then they are probably a wage-earning employee. For more details, consider the following examples from the IRS.

Vera Elm, an electrician, submitted a job estimate to a housing complex for electrical work at $16 per hour for 400 hours. She is to receive $1,280 every 2 weeks for the next 10 weeks. This is not considered payment by the hour. Even if she works more or less than 400 hours to complete the work, Vera Elm will receive $6,400. She also performs additional electrical installations under contracts with other companies that she obtained through advertisements. Vera is an independent contractor.

Donna Lee is a salesperson employed on a full-time basis by Bob Blue, an auto dealer. She works 6 days a week, and is on duty in Bob's showroom on certain assigned days and times. She appraises trade-ins, but her appraisals are subject to the sales manager's approval. Lists of prospective customers belong to the dealer. She has to develop leads and report results to the sales manager. Because of her experience, she requires only minimal assistance in closing and financing sales and in other phases of her work. She is paid a commission and is eligible for prizes and bonuses offered by Bob. Bob also pays the cost of health insurance and group-term life insurance for Donna. Donna is an employee of Bob Blue.