Payroll vs. Contractor: Confusing This Can Cost You

I often meet with potential clients to review their books. One of the most misclassified expense items is their payroll expense line. When I see payroll expense, I start asking questions. 

The first question is asking for a payroll report. Many small business owners classify paying anyone for working for them as payroll expense. Several are paying independent contractors and calling it payroll, while others are running true payroll.

What is payroll? 

Payroll is the total of all compensation/wages a business must pay to its employees for a set period of time or on a given date. True payroll will have federal taxes withdrawn from the employee's compensation. It will include accounting, record-keeping, and setting aside funds for Medicare, social security, and unemployment taxes — both the employee and employer portions.

What is the difference between payroll and paying an independent contractor? 

Payroll will have payroll tax implications with each payment received. Paying an independent contractor (1099) will not. Many business owners feel they cannot afford the employer portion of payroll taxes on top of the wages due. Many will just bring in workers as independent contractors to offset those taxes. This is not a good workaround.

The law has specific guidelines as to the difference between an employee and a contractor. The State of Florida Dept of Revenue states: “If the employer retains the right to dictate how the work should be done, the worker is an employee….If the employer decides what work the worker will do and how the worker will do it, then the worker is an employee…. If the service provided by the worker is an integral part of the service the employer provides to the public, the worker is more likely to be an employee.” 

Those are just a few of the indicators that the person is an employee, not a contractor and wages are subject to payroll taxes.

Many feel that it’s just verbiage saying payroll and employee instead of contractor or vendor. It really does matter. If the contractor or auditor believes they really are employees, there can be financial consequences. 

If the IRS determines that an individual has been misclassified, they may levy penalties against the employer, including, but not limited to, a $50 fine for each W-2 the employer failed to file, a penalty of 1.5% of the wages, plus 40% of the FICA taxes that were not withheld from the employee, and 100% of the matching FICA taxes the employer should have paid. The state will also be able to impose tax penalties and fees.

It is important to know the difference and make sure to classify currently.