Is It Better to Be Taxed as an Employee or Independent Contractor?

A reader writes in, asking:

“I just started a new position and the company is letting me decide whether I want to be taxed as an employee or an independent contractor. What factors should I be considering in order to make this decision?”

Firstly, we need to back up a step, because this question sets off some alarm bells.

It is the facts and circumstances of the work relationship that determine whether a worker is an employee or an independent contractor. Generally speaking, the more control the business has over the worker, the more likely it is that the worker is an employee rather than an independent contractor. (IRS Publication 15-A has more details.)

In other words, if the facts and circumstances of the work suggest that you are an employee, the business cannot simply decide you are an independent contractor and handle everything accordingly. And in fact many employers get in trouble with the IRS every year as a result of having misclassified their employees as independent contractors.

The key point here is that, in the event that you really do have a choice between being an independent contractor or an employee (i.e., it is not simply a case of the business misunderstanding the rules and thinking that they can treat you as either one without any substantial difference in the work relationship), there are going to be factors other than taxation involved.

So What Are the Tax Differences?

From a tax perspective, there are both pros and cons regarding the tax treatment for independent contractors as compared to employees.

As an employee, you are responsible for paying Social Security and Medicare taxes in the amount of 7.65% (2.9% for amounts beyond the current Social Security earnings limit), and your employer pays a matching amount. As an independent contractor, you have no employer, so you get stuck with both halves of the bill (in the form of a 15.3% self-employment tax).

Another disadvantage of being an independent contractor is that it requires somewhat more administrative work. You’ll have to fill out Schedule C along with your Form 1040 every year to calculate the profit or loss from your business. In addition, because nobody will be withholding taxes from your income, it will (in most cases) be necessary for you to make estimated tax payments throughout the year.

On the other hand, one advantage of independent contractor tax treatment is that your work-related expenses will be business expenses, which will save you money on income tax as well as Social Security and Medicare taxes. In contrast, as an employee, unreimbursed work expenses are generally itemized deductions, meaning that you get no value from them if you use the standard deduction each year. In addition, they’re in the category of itemized deductions from which you must subtract 2% of your adjusted gross income before even being allowed to include them as an itemized deduction. (See the instructions to Schedule A for more information.)

An additional advantage of being an independent contractor is that you’ll have additional retirement plan options available to you. Most importantly, you’ll be eligible for a solo 401(k) — alternatively referred to as an individual 401(k) — for which the contribution limits are quite high.