Employee or contractor at $20 an hour: the $3,224 that moves

Pay two people $20 an hour for the same 2,080 hours, one as an employee and one as a contractor, and both receive $41,600. The business does not pay the same for them. The employee costs it $3,224 more in federal payroll tax, and that money does not vanish for the contractor. It moves.

What the business pays

For the employee, three federal taxes are charged to the employer on top of the wage: Social Security, Medicare and federal unemployment tax. On $41,600 they come to $3,224.40, so the year costs $44,824. The line-by-line working is here.

For the contractor, the business pays the invoice. It generally owes none of those three taxes on it, so the year costs $41,600.

Same pay, same hours: $44,824 for the employee and $41,600 for the contractor. The difference is the employer’s payroll tax, and it is the floor, not the whole gap.

Where the tax goes

Of that $3,224.40, $3,182.40 is the employer’s share of Social Security and Medicare: 7.65% of pay. A contractor still owes it. A self-employed person pays both the employee’s and the employer’s share through self-employment tax, which the IRS works out on a slightly different base and sets out on Topic 554.

So the $20 an hour is not the same $20. The employee’s $20 arrives with the employer’s share already paid by someone else. The contractor’s $20 has that share still to come out of it.

The gap is usually wider than the tax

Payroll tax is only the part of an employee’s cost that every employer pays. Most pay more: state unemployment tax, workers’ compensation insurance, a share of health cover, a retirement contribution, paid leave. A business does not pay those for a contractor, who covers their own insurance, their own retirement and their own days off out of what they invoice.

Take the same example figures as before. They are an illustration, not typical values: 2.7% state unemployment tax on the first $9,000 of pay, $6,000 a year towards health cover and a 3% retirement contribution. With those, the employee costs $52,315 a year, which is $10,715 more than the contractor’s $41,600.

The rate at which they cost the same

Turn it round and ask what hourly rate a contractor would have to charge to cost the business exactly what the employee does.

• Against federal payroll tax alone: $21.55 an hour.
• Against the example with benefits: $25.15 an hour.

That is one way to read a contractor’s rate. A rate that looks well above a wage may only be the same cost with the taxes and benefits moved inside it, and a rate equal to the wage is a lower one once the contractor has paid what the employer otherwise would.

What this does not tell you

Which of the two a worker is, is not a choice between two prices. It depends on the facts of the working relationship, not on what the contract calls it, and the IRS can review it. Its own explanation is here. Nothing in this article says how any worker should be classified.

The arithmetic above is federal only and uses one wage. The employee cost calculator runs the employee side for any pay, with the rates as fields you can check and your own state tax and benefits added.