Employee vs. Independent Contractor Issues

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More and more individuals are working as freelancers and independent contractors these days. However, the IRS would generally prefer you to be an employee.

  • As an employee, your employer is primarily responsible for seeing your taxes are paid. The employer withholds income taxes and your share of Social Security and Medicare taxes from your wages. As an independent contractor, you are considered self-employed for tax purposes and are responsible for your own tax payments.
  • As an employee, you can deduct out-of-pocket business expenses only if you itemize your deductions and, even then, your deduction is limited. As an independent contractor, your can deduct your business expenses in full on Schedule C of Form 1040.
  • As an employee, you can deduct what you spend on medical insurance only if you itemize and only to the extent that your total medical expenses exceed 10% of your adjusted gross income. As an independent contractor, your medical insurance premiums are deductible in full.

The problem is that it is sometimes difficult to determine whether an individual is an employee or an independent contractor-and this leads to disputes with the IRS. Individuals' work arrangements with customers and clients come in all shapes and sizes. But, regardless of what label you put on a relationship, the key issue as far as taxes are concerned is control-the more control a customer or client has over your work, the greater the chance you should be classified as an employee instead of an independent contractor.

The courts have considered many factors in deciding whether an individual is an independent contractor or an employee. These factors fall into three main categories: behavioral control, financial control, and relationship of the parties. In each case, it is very important to consider all the factors - no single one provides the answer.

  1. Behavioral control. An individual is an employee when the business has the right to direct and control the individual. For example, if you receive extensive instructions on how work is to be done, this suggests that you are an employee.
  2. Financial control. These factors show who there is a right to control the dollars-and-cents part of the work arrangement. For example, if you have a significant investment in your work, this tends to favor an independent contractor status. On the other hand, if customers and clients reimburse you for your business expenses, this may indicate an employer-employee relationship.
  3. Relationship of the parties. These factors show how you and your customers or clients perceive your relationship. For example, if you receive paid leave or benefits, this favors an employee status.
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