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What's the difference between an employee and contractor?

The core difference is control. Employees work under your direction. You decide when they work, where they work, and how they do the job. Contractors control their own methods. You agree on the end result, but they determine how to get there.

This distinction drives your tax obligations. With employees, you withhold federal and state income taxes from their paychecks. You withhold Social Security and Medicare, then pay a matching amount from your own pocket. You file quarterly payroll returns, pay state unemployment taxes, and issue W-2s at year end. Arizona also requires workers’ compensation coverage for employees.

With contractors, you don’t withhold anything. You pay the agreed amount in full and issue a 1099-NEC if you paid them $600 or more during the year. They handle their own income taxes and self-employment taxes. No quarterly payroll filings on your end, no employer tax contributions, no workers’ comp requirements for their work.

The IRS uses three categories to determine classification. Behavioral control looks at whether you direct what the worker does, when they do it, and how. Financial control considers who provides equipment, whether the worker can profit or lose money on the job, and whether they offer services to other clients. Type of relationship examines contracts, benefits, and how central the work is to your business.

No single factor decides the classification. Someone might use your office but still be a legitimate contractor if they set their own hours, work for other clients, and control their methods. But if you dictate their schedule, give step-by-step instructions, provide all their tools, and they work exclusively for you, calling them a contractor doesn’t make it true.

The cost difference between employees and contractors is real but often overstated. You avoid payroll taxes and benefits with contractors, but contractors typically charge higher rates to cover their own taxes and overhead. The classification should reflect the actual working relationship, not a strategy to reduce costs. Our Phoenix area bookkeeping services regularly help business owners understand these distinctions and set up proper tracking for both worker types.

Misclassification creates problems. The IRS can assess back taxes, penalties, and interest for employees you incorrectly treated as contractors. Arizona follows federal guidelines and will also pursue unpaid unemployment taxes. Beyond tax issues, misclassified workers can file unemployment claims or workers’ comp claims that create unexpected liability.

If you have employees, you need payroll systems that handle withholdings, filings, and compliance correctly. If you have contractors, you still need to track payments and issue 1099s accurately. When you’re unsure about classification, err toward employee status. The cost of treating a contractor as an employee is minimal. The cost of treating an employee as a contractor can be substantial.

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More Questions

How do I track business expenses properly?

Start by separating business and personal finances completely. Use accounting software with bank feeds, categorize transactions weekly, and keep documentation for everything you plan to deduct.

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What receipts do I need to keep for tax purposes?

The IRS requires receipts for expenses over $75 and all lodging expenses regardless of amount. Below $75, other documentation can work, but receipts are always the strongest proof if you're audited.

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How do I handle Arizona sales tax collection?

Register for a Transaction Privilege Tax license with the Arizona Department of Revenue, then collect at the combined state, county, and city rates based on where your business is located. Arizona uses an origin-based system, so your location determines which rates apply for most in-person sales.

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How do I track inventory across multiple Amazon warehouses?

Amazon automatically distributes FBA inventory across fulfillment centers and tracks it for you. Your job is pulling the right reports and reconciling Amazon's data with your accounting records.

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How do I track cash register shortages in my accounting?

Create a cash over/short account and record the difference between your expected drawer total and actual count each day or shift. This gives you visibility into patterns and helps identify whether shortages are normal variance or a bigger problem.

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What financial reports does a retail business need each month?

Retail businesses need a profit and loss statement, balance sheet, cash flow report, and inventory-specific reports like aging and turnover. These reports help you track margins, manage cash tied up in products, and make smarter buying decisions.

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