Using Contract Labor as a Tax Deductible Expense

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Contract labor is the use of independent contractors that is tax deductible. From a tax perspective, the difference between contract labor and an employee is like day and night.

Key Takeaways

  • A worker is defined as a contractor by the IRS if the company they are doing work for can control the result of the work only, not how it is done.
  • An employee is on the payroll and receives benefits. An independent contractor is not, and their wages are tax deductible for the business.
  • Some companies hire contractors instead of employees to save on the cost of having them "on the books."

The Internal Revenue Service's general rule is that "an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done."

A more workable definition of independent contractor status comes from common law principles which focus on the method of compensation. If an individual is on your payroll and receives a steady paycheck, clearly that the person is an employee rather than an independent contractor. Independent contractors usually operate under a specific contract and invoice for work completed. Other considerations that identify an individual as an independent contractor include:

  • If the worker supplies his or her own equipment, materials, and tools.
  • If all the necessary materials are not supplied by the employer.
  • If the worker can be discharged at any time and can choose whether or not to come to work without fear of losing employment.
  • If the worker controls the hours of employment. 
  • Whether the work is temporary or permanent.

Contract Labor and Your Small Business Taxes

The earnings of a person who is working as an independent contractor are subject to the self-employment tax. Independent contractors are self-employed, and therefore, they are not covered under most federal employment statutes. They are not protected from employment discrimination under Title VII, nor are they entitled to leave under the Family Medical Leave Act. You don't have to pay them benefits, Social Security, Medicare, workers' compensation or state unemployment taxes.

Wages paid to independent contractors can be deducted from your taxable income. For tax purposes, you must provide these individuals with the IRS form 1099-MISC and provide the IRS with Form 1096 to show how much you paid them. Of course, you should consult with your tax and accounting professionals to determine exactly what write-offs are legal and what procedures to follow and what forms to use.

Tax Consequences If You Are a Contract Laborer

As an independent contractor, it's important that you pay estimated taxes, keep good records and know the deductions that may apply to you, which may include:

  • Home office deduction
  • Travel expenses, including your car
  • Health insurance premiums
  • Retirement account contributions
  • Depreciation of property and equipment
  • Educational expenses


Consult your tax and accounting professionals for guidance and compliance.

When To Hire Contractors Instead of Employees

Some companies opt to hire contractors instead of employees, in large part to save on the high cost of having them "on the books," which could easily inflate your payroll costs by 20% to 30%. Other advantages include the following:

  • You get the flexibility to expand or contract your workforce as needed. If you hire for a specific project, the expense is gone when the project is done. It's preordained so there's no trauma or legal trouble that can accompany letting someone go.
  • You get greater efficiency because many independent contractors bring specialized expertise, which also eliminates the time and cost of training.
  • You risk potentially fewer lawsuits as independent contractors are not protected by such state and federal laws like the right to the minimum wage or overtime, protection against certain discrimination, the right to form a union or take paid sick leave.

Some disadvantages include:

  • You get less control because independent contracts are just that: independent. Also, if you exercise too much control, the IRS may think they are really employees.
  • You have less stability in the workforce. These folks come and go, which also means less loyalty.
  • Your right to fire an independent contractor depends on your written agreement with them, or you're looking at a breach of contract.
  • You may be liable if they are hurt or injured on the job.
  • You may not own the copyright to the work or intellectual property that they create unless specified in your written agreement.
  • State and federal agencies want to see workers as employees because that means more tax revenue. You might be subject to an audit.


How much can I pay a contractor before having to file a 1099-MISC?

According to the IRS, you must file a Form 1099-MISC for each worker that you may more than $600 over the course of the year.

As a contractor, how much should I hold back for taxes?

As a contractor, a good rule of thumb is to set aside 25% to 30% of your taxable income to pay both quarterly taxes and any additional tax that you owe when you file your taxes in April.

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Updated by Taylor Tompkins
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The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
  1. Internal Revenue Service. "Independent Contractor Defined."

  2. Social Security Administration. "How to Apply the Common Law Control Test in Determining an Employer/Employee Relationship."
  3. Internal Revenue Service. "About Form 1099-MISC."

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