If a worker is an employee, the employer is responsible for paying Social Security, unemployment insurance, Medicare, and possibly other costs like workers' compensation insurance for the employee; at the end of the tax year, the employer is responsible for compiling all necessary payroll reports, including W-2 forms.
If a worker is an independent contractor, the employer is not responsible for any of the above taxes or payments, and the only added paperwork is the issuing of a 1099 to the independent contractor at the end of the tax year, if he or she has made more than $600 with the employer.
So why not just call everyone who works for you an "independent contractor" and save time and money? Because you, as the employer, are not the one who decides whether someone is an employee or an independent contractor; the law does, and there could be penalties if you make an incorrect determination.
Employee or Independent Contractor?
The IRS (Internal Revenue Service) lists three categories of information to be considered in the determination of whether an individual is an employee or independent contractor:
An employer must show there is a reasonable basis to classify the worker as an independent contractor in order to escape the burden of paying taxes for the worker.
If you still aren't sure whether a worker is an independent contractor or employee, the IRS provides Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding (PDF); either the worker or the employer can fill out and send in the form, and the IRS will review the situation and tell you its determination on the matter.
Claiming an Employee as an Independent Contractor
If you have claimed an employee as an independent contractor, the IRS may hold you responsible for employment taxes for that worker; there are steeper penalties for "willful neglect" as well under Internal Revenue Code Section 3509.