Understanding the Tax Implications of Hiring Contractors vs. Employees

Defining an Employee vs. an Independent Contractor

Your tax and reporting obligations vary significantly depending on whether a given individual you work with is an employee or an independent contractor. We will focus on the definitions of each for federal tax purposes. Generally, independent contractors bring less tax and reporting responsibilities, but you have less control over the work they perform.

Types of Workers

The Internal Revenue Service (IRS) classifies workers as being:

• Employees

• Independent contractors

• Government workers

• Statutory employees

• Statutory nonemployees

  
  

A local, state, or federal agency employs government workers. Statutory employees are individuals who may fit into the definition of independent contractors but whom the government still requires businesses to treat as employees. Certain delivery drivers, insurance sales agents, individuals who perform work on goods you directly provide, and traveling salespeople fall into the statutory employee category.

The IRS Independent Contractor Test

The federal government uses the IRS independent contractor test to determine a worker’s status as an employee or contractor. The test offers three factors to help decide whether someone is an employee or an independent contractor, based on all relevant circumstances.

These factors include:

• Behavioral control—the degree to which the business has the right to control how the individual performs the work

• Financial control—the degree to which the business has the right to control the economic aspects of the work

• Type of relationship—the nature of the relationship, particularly with respect to the existence of written contracts, benefits, long-term expectations of the relationship, and how essential the services provided are to the business

  
  

These factors help demonstrate the worker’s relative degree of control and independence. Generally, the IRS considers function over form—it evaluates how the relationship actually works, not how you say it works. If you’re interested in a home business, read about these 7 home business ideas that double as tax write-offs.

Behavioral control

The government evaluates how much behavioral control a business has over a worker based on the following:

• Type of instructions—the amount of direction given concerning when, where, and how to perform the work

• Degree of instruction—how detailed any instructions are about how to perform the work

• Evaluation systems—whether the business uses an evaluation system to measure how workers perform their assignments

• Training provided—whether the business provides training and how extensive that training is

  
  

In general, the more instruction, training, and evaluation the business provides, the more likely the worker is to be an employee rather than an independent contractor.

Financial control

How much financial control a business has typically depends on:

• Significant investments by the worker—whether the worker has invested their own money in equipment or tools they use to perform the work

• Reimbursement of expenses—whether the business reimburses expenses

• Opportunity to profit or lose—whether the worker may earn a profit or lose money from the work independently from the business’s profits or losses

• Availability of services—whether the worker offers services to others

• Payment method—whether you pay the worker a flat or an hourly rate

  
  

In general, the more separate financial control the worker has, the more likely they are an independent contractor.

Type of relationship

The specifics of the working relationship affect whether the worker is an independent contractor as follows:

• A written contract declaring the worker is an independent contractor will not prevail over evidence that the relationship works like an employer–employee relationship.

• Businesses typically do not provide benefits like insurance, retirement, sick leave, or vacation days to independent contractors.

• Businesses typically hire independent contractors for specific projects or periods rather than indefinitely.

• Independent contractors typically do not perform key business functions.

  
  

No one factor controls the determination. 

How Do Taxes Work for Employees?

Hiring employees comes with more tax obligations than hiring independent contractors. When you hire employees, you must begin withholding amounts from their paychecks, regularly depositing the taxes you collect, and meeting reporting requirements.

What Tax Obligations Do Employers Have?

As an employer, you usually withhold the following from your employees’ paychecks:

• Federal and, if applicable, state income taxes

• Social Security taxes

• Medicare taxes

  
  

Together with the employer’s portion, these obligations represent your payroll taxes. 

Employers must also regularly pay a Federal Unemployment Tax Act (FUTA) tax and state unemployment taxes. If you’re considering launching a new business, read about tax essentials for startups.

How Much Are Employer Payroll Taxes?

If you are an employer, at some point, you must ask: How much are employer payroll taxes? Payroll taxes for 2025 include:

• Income taxes—consult employee’s W-4

• Social Security—6.2%

• Medicare—1.45% and an additional 0.9% for wages above $200,000

  
  

While income tax is generally deducted from an employee’s gross pay, the employer and employee each pay 6.2% Social Security and 1.45% Medicare taxes. The employer withholds but is not required to match the additional Medicare tax. Businesses should also remit approximately 6.0% of the first $7,000 in wages per employee for FUTA and the relevant amount for state unemployment taxes.

What Reporting and Depositing Obligations Do Employers Have?

Employers must generally deposit withheld taxes and the employer portion of taxes with the IRS on a semi-weekly or monthly schedule, while FUTA taxes are usually calculated and deposited quarterly. The IRS prefers that businesses use its online web portal. They should also e-file corresponding forms, available on the IRS website. Most businesses have to file quarterly payroll reports. However, if your employment tax liability is $1,000 or less per year, you can file annually with IRS approval. 

How Do Taxes Work for Independent Contractors?

They bring fewer tax obligations, but how do taxes work for independent contractors? Usually, an independent contractor is responsible for paying what would be your share of payroll obligations. And you need not collect FUTA taxes for individuals you do not, in the legal sense, employ.

Unlike the several obligations associated with employees, you typically need only to file regular reports to keep up to date on your obligations related to independent contractors. You file Form 1099-NEC, Nonemployee Compensation, to report amounts you pay above $600 annually to any independent contractor.

Other Definitions of Employee vs. Independent Contractor

Although we have focused here on the IRS definitions of employee and independent contractor, it is important to note that the Department of Labor (DOL) and various states may follow different guidelines such as the Fair Labor Standards Act (FLSA) rule. It is important for businesses to be aware of such differences and how they might impact the organization’s classification of workers.

Hiring an Employee vs. an Independent Contractor

Ultimately, hiring someone as an employee comes with more responsibilities but allows you greater control over the activities they perform. Hiring someone as an independent contractor lowers your responsibilities but limits how much you can control the work they do for your company. Which would work better for your organization depends on its unique needs and your vision for its future.

Disclaimer: Bizee and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction. 

Resources:

• IRS, Behavioral control, link.
• IRS, Depositing and reporting employment taxes, link.
• IRS, Employee (common-law employee), link.
• IRS, Employment tax due dates, link.
• IRS, Financial control, link.
• IRS, Independent contractor defined, link.
• IRS, Independent contractor (self-employed) or employee?, link. 
• IRS, Publication 15: Federal Unemployment (FUTA) Tax, link.
• IRS, Publication 15: Social Security and Medicare Taxes, link.
• IRS, Reporting payments to independent contractors, link.
• IRS, Statutory employees, link.
• IRS, Statutory nonemployees, link.
• IRS, Type of relationship, link. IRS, Worker Classification 101: employee or independent contractor, link.