The distinction between and employee and an independent contractor is an important one for business owners to keep in mind, as it has all sorts of legal implications that cover a number of issues, including workers' compensation, employee benefits and the like.
This distinction also has important implications when it comes to payroll taxes, or those withholding such as income tax, Social Security and Medicare that are supposed to come out of an employee's paycheck. Unlike employees, an employer has no obligation to withhold these taxes on behalf of an independent contractor, as that person must see to it himself that the proper taxes get paid.
For federal tax purposes, an employee is someone over whom the person or business hiring him or her exercises significant control over the worker as to the details of the worker's job. In some cases, this is pretty clear cut.
The plumber who has to come in once or twice a year to fix a leaky pipe in a small business is pretty clearly an independent contractor who likely has a number of customers, while the person working behind the cash register of a mom and pop diner is going to probably be treated as an employee.
In some cases, though, there is a grey area, and it may not be clear whether a worker was an employee. These sorts of situations can lead to a full-blown tax controversy if the IRS tries to claim the worker was indeed an employee and that, therefore, the employer should be held accountable for the worker's payroll taxes. These sorts of disputes may require the assistance of an experienced tax attorney to help sort out.