When a business pays workers, a major question that must be answered is whether they are employees or independent contractors. The difference in tax treatment is significant: if you pay employees, you must register with the IRS and state governments, pay several federal and state employment taxes based on the wages you pay, withhold employment taxes and income tax from your employees’ wages and turn them over to the IRS on a regular basis. You must also carry several types of insurance in most states. By contrast, there are no taxes associated with independent contractors and a business will only issue them a single income reporting form at year-end.

The IRS uses a 20 factor test to determine if a worker is an employee or independent contractor; the overall intent is to understand if the business exerts significant control over how, where and when the worker does his job. As an example, your office manager, who works only for you, must report to your office at specific hours, takes direction from you regarding how to do his job, and gets paid at regular intervals, is an employee. Conversely, your doctor, who has many patients, maintains his own office and hours, has his own training and instruments, and gets paid per visit, is an independent contractor.

If you misclassify an employee as an independent contractor, and you do not pay employment taxes, you may be liable for significant interest and penalties. As this is an area of significant revenue for the government, compliance is strictly enforced. Furthermore, payroll tax liabilities are the personal responsibility of company officers, even in a corporation.