Difference Between an Employee & Subcontractor

by Devra Gartenstein, studioD

Most small business owners need assistance in performing their company's daily operations. The terms of your working relationships with the individuals you hire to help out will determine whether you treat them as employees, who are linked to your company in complex ways, or as subcontractors, who are independent operators responsible for their own taxes and bookkeeping. The determination has implications for your tax liabilities as well as your obligations and commitment to the individual worker. It also determines whether he's entitled to benefits such as unemployment and industrial insurance.

Contractors and Subcontractors

When you enter into a business relationship or transaction, you agree to provide a product or service in exchange for a sum of money. You're acting as a contractor, whether or not you've created and signed an actual contract with your client. If you hire someone else to perform some of the work you have promised to deliver, you create an implicit or explicit contract within a contract, or a subcontract. As a business owner, you may pay both employees and independent subcontractors to perform work for you.

Definition of a Contractor

Work arrangements governing when to treat a worker as a contractor or subcontractor and when to treat him as an employee are complex and multifaceted. Even the IRS tiptoes around the issue, providing general guidelines rather than rules. Despite the agency's vagueness, its agents are quite serious about implementing and enforcing regulations concerning whether to treat a particular worker as an employee or a subcontractor. In general, if a person who performs a service for you makes autonomous decisions about how to perform that work, he can be considered a subcontractor. But if you dictate the terms and specifics of how he works, he's an employee. For example, if you tell a worker simply to dig up a customer's yard and let him use any tools he has available, he's a subcontractor. But if you tell the same worker to use a rototiller and start on the east end of the yard, he's more likely to be considered an employee.

Definition of Employee

According to the IRS, a worker's status as an employee hinges on three fundamental criteria for determining the extent of control that she exercises over his work. The behavioral criterion covers the way that work is performed, such as the direction to use a rototiller to till the yard. The financial criterion determines control over the financial resources required to get a job done. When an employee drives his own car in the course of performing a job, it's reasonable for him to expect his employer to reimburse him for driving these miles; however, when a contractor or subcontractor does the same thing, his transportation expense is his own responsibility. In addition, the IRS uses a relationship criterion to determine whether a worker is legally an employee or a subcontractor. The relationship between employer and employee is more complex and extensive than that of business owner and subcontractor, and may include perks such as health insurance and an ongoing commitment to provide a specified number of hours.

Tax Consequences

The designation of employee or subcontractor status has tax implications for both you and your worker. Employers must pay Social Security and Medicare taxes for employees, while subcontractors are responsible for the self-employment taxes that cover their own Social Security and Medicare contributions. In addition, employers must pay state and federal unemployment taxes as well as state industrial insurance taxes for the workers they list as employees.

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