Small businesses often do not understand the effect of classifying an individual as an employee or an independent contractor. Correctly classifying an individual as either an employee or an independent contractor is important for business owners and managers. The effect of misclassification can be painful and expensive.

When a company properly classifies an individual as an independent contractor it can save money for administration, pensions, workers’ compensation insurance, group health insurance, unemployment insurance and social security taxes.

In most cases, employers only need to complete a Form 1099-MISC for each worker classified as an independent contractor. Alternately, classifying workers as employees requires that the company: withhold local, state and federal income taxes; pay half of the tax required under the Federal Insurance Contributions Act (for Medicare and Social Security) and pay federal unemployment insurance.

In addition some states require workers’ compensation insurance and State Unemployment insurance and require employers to submit a number of returns during the course of each year. W-2s must be provided to tax authorities and employees by January 31st each year. Employees may have rights to participate in any employee benefits, such as vacations, holidays and retirement plans.