One of the most basic steps of the payroll process is distinguishing between employees and independent contractors. However, employers are sometimes foggy on what differentiates the two types of workers. Employers should have a solid idea of these concepts because there are significant tax implications.

Independent contractors are becoming more and more popular among companies because they serve an important function. Just as you might not need a full-time doctor or lawyer on staff, small businesses are starting to use independent contractors for marketing, design, and other roles that used to be occupied by a full-time person.

Our data at SurePayroll from surveying small business owners has shown a gradual increase in the percentage of 1099 workers since 2004, rising from nearly 2.9 percent to 6.7 percent.

Let’s look at how an independent contractor might affect your small business payroll:

  • Taxes. Tax withholding is not required for independent contractors. The company does not have to pay Social Security or Medicare tax or federal and state unemployment insurance contributions.
  • Work schedule. Independent contractors set their own hours and sequence of work. They can work for multiple employers, and their services are available to the public. They tend to work job-by-job rather than on a continuing basis with a single employer.
  • Budget. Employers can often save money using independent contractors, not only because of the tax situation but also because they’re not providing supplies, work space, or equipment. The independent contractor takes on the risk of profit or loss. Employers generally agree on a price or an hourly rate rather than a continuing salary with benefits and reimbursements for expenses.

There are two ways an employer can go about determining a worker’s status. One is the Common Law Test, which asks how independent the employee is based on the points discussed above. However, there are exceptions, and employers can also use the Reasonable Basis Test, which allows them to designate someone as an independent contractor for tax purposes if there is a reasonable basis to do so.

A worker or employer may request the IRS’s determination of the worker’s status by filing Form SS-8.

The next question becomes how you decide what kind of worker you want to hire. Before you make the decision, consider a few more factors:

  • Need. Are you working on some type of seasonal campaign or a one-off project for which your current staff doesn’t have time? If so, consider an independent contractor. If you’re generally understaffed, however, and you need someone you can count on for more than just a few months or a year, you may want to consider adding a regular employee.
  • Cost. As long as the person meets the criteria for an independent contractor, hiring this type of employee can mean savings over the long term, though you might pay more short term on an hourly basis.
  • Dependability. This is an issue with anyone you hire, but with an independent contractor the required supervision should be much less. Do your research when hiring so you can be confident you’re getting someone you can trust to work on his or her own.

Finally, remember that even though you are not required to withhold taxes on an independent contractor, you still must fill out the Form 1099-MISC. If you have questions on this, be sure to talk with an accountant or your payroll services provider.

Michael Alter is president and CEO of SurePayroll, a wholly owned subsidiary of Paychex. SurePayroll provides payroll services for small businesses.