Payroll Tax: Employee vs Independent Contractor

When it comes to hiring workers, businesses often face the decision of whether to classify them as independent contractors or employees. While both serve essential roles, there are significant tax implications associated with each classification. In this article, we’ll explore the differences between contractor and employee taxes, helping business owners make informed decisions.

Employees and independent contractors are two different types of workers. Misclassifying them may lead to serious penalties, so it is important that the distinction is clearly understood.

Employees are dependent on their employers. That’s why employers are subject to multiple taxes. Funds acquired through taxes are supposed to help protect employees in case of disability or job loss.

Employee payroll costs consist of many parts, and the obligatory part is tax. Here are most popular types of tax that are associated with employment:

Payroll tax. The umbrella term refers to various taxes that employers and employees pay on wages and salaries. These taxes fund social security and medical care payments to be made to former employees in future. The payer can be either the employer or the employee. It also varies by country.

Social Security tax. This is a percentage of wages that all employees, employers and self-employed must pay. The tax feeds support programs for the retired, disabled and other vulnerable categories of workers. Not all countries have this kind of tax.

Medical care/Insurance. The funds collected through this tax go to medical care for workers. In countries like the US where medical care is not free the money provides medical care for senior and disabled citizens. However, in other countries with free public health care there may not be a tax like this but an employee benefit instead.

Unemployment tax. The funds acquired through this tax are directed to people who have lost their jobs. The tax is paid solely by employers, and employees are not subject to it.

The types of taxes that the employee is obliged to pay are different from nation to nation, along with the percentage that taxes comprise. However, there are similarities, and the types presented above are more or less common across legislation.

Exactly how much tax is to be paid by freelancers is a tricky question. The trick is that contractors pay tax off of profits, not total earnings. To get to profit, you need to deduct business expenses from earnings. What exactly is considered a deductible business expense is defined differently across nations.

What seems more common is that freelancers are required to make quarterly estimated tax payments. There may be penalties for missed deadlines, so it’s crucial that contractors are extra careful with money.

Keeping an employee may be costly for some businesses, especially small and medium enterprises. This may lead to cost-cutting measures to keep the business going. Yet doing so through calling employees contractors is dangerous. The underlying intention is to cut on payroll tax, but it only leads to further spending on fees and penalties.
What such companies may be accused of is employee misclassification. It is when employers knowingly misclassify their employees as contractors to avoid tax responsibilities and relieve the tax burden.
The problem behind this move is that the employer basically excuses themselves from proper worker protection. Instead of offering a dependent worker benefits of employment, they don’t provide necessary benefits that workers are in fact entitled to — namely, overtime pay, health benefits, insurance, etc.
Worker misclassification entails several serious violations that can be summarized as follows:

• Tax Implications. Failing to pay employer taxes (e.g. Social Secutiry) and employee tax (e.g. income tax) can result in criminal charges, such as tax fraud, for both parties. A top-level consequence is economic downturns triggered by lesser amounts of money collected through tax.
• Labor Law Violations. Misclassified employees may be denied protections under labor laws, including minimum wage, overtime pay, and government-imposed safety standards.
• Benefits Violations. Employees may be deprived of benefits typically provided to employees, such as health insurance, paid time off, workers' compensation, and retirement benefits.
• Unemployment Insurance Violations. Employers do not contribute to unemployment benefits for misclassified workers.

Ultimately, employees are bound to face severe legal consequences for worker misclassification. These may include:

• Mandatory payment of back wages, including overtime pay
• Penalties and assessments for payroll taxes
• Workers' compensation premiums and penalties
• Compensation for benefits, leave entitlements, and associated penalties

A recent high-profile case is the legal battle between Uber and California. In 2020, the California Labor Commissioner’s Office sued Uber, claiming they had misclassified their drivers as contractors instead of employees, resulting in unpaid wages and benefits.
The lawsuit demanded unpaid taxes, penalties, and damages amounting to millions. It was settled in 2022, with Uber agreeing to pay $ 8.43 million, an average of $ 8,000 per driver.

This settlement was one of the largest ever in a misclassification case and emphasizes the risks employers take when incorrectly categorizing workers as contractors. It has also impacted the gig economy and worker classification practices, with many companies facing increased scrutiny after this ruling.

So is there a way to compliantly run freelance teams? With so much scrutiny that companies face at home, how can a business manage freelance teams offshore?

EasyStaff is the contractor management platform that acts as a B2B contractor for companies. It receives money from companies and redirects it to their freelancers thus being a mediary between parties. EasyStaff provides closing documents, so businesses can legally declare their spendings as contractor payments. From freelancers' point of view, they receive money from a B2B client and receive closing documents as well to make their income legal.