FICA and Unemployment Taxes

Businesses have to withhold and pay Social Security and Medicare (FICA) taxes on wages paid to an employee. At a 7.65% tax rate (1.45% on 2006 wages exceeding $94,200), the employer's share of FICA taxes can add up fast. No withholding or FICA payment is required for an independent contractor  because a contractor is “self-employed” and personally responsible for the payment of self-employment taxes on his or her earnings. Federal and state unemployment taxes are additional expenses of having an employee that can be avoided by hiring an independent contractor.

Employee Benefits

Health and retirement benefits are expensive to provide, so companies naturally want to avoid covering workers that can rightfully be excluded. However, denying coverage to “contractors” who later prove to be employees can have serious consequences.

A case involving software giant Microsoft brought national attention to this issue several years ago. A number of freelancers were working for Microsoft at the time the IRS examined the company's employment records for compliance with the tax laws. Despite written agreements stating otherwise, the IRS decided that Microsoft's freelancers were actually the company's employees for withholding and employment-tax purposes based on common-law principles. This ruling prompted several of the freelancers to ask for employee benefits. Microsoft refused the benefit requests, and the controversy ultimately went to a federal appeals court, which decided that the freelancers were entitled to participate in the company's 401(k) and stock purchase plans. The Microsoft case stands as but one example of the fine line that so often exists on the worker classification issue.