If you’re bringing on a new hire, you’ll need to classify them as either an employee or an independent contractor.
An independent contractor is typically someone who can work from any location during a time of their choosing. They can work for multiple companies, using their own tools and resources, and are often paid on a project or flat-fee basis. An employee is someone who works specific hours at a location chosen by the employer. They generally work only for one company, use the employer’s tools and resources, and are paid a salary or an hourly wage.
While the above explanation might sound simple, it’s a bit more complicated than you might think. We’ll walk you through the differences between an independent contractor versus an employee and why they matter.
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How to tell the difference between an independent contractor vs. employee
While the IRS, the Fair Labor Standards Act, and the common law have all helped define the differences between an employee and an independent contractor, the difference between the two is not totally cut and dry.
The IRS generally assumes an employee relationship, but the line can sometimes be ambiguous.
This handy chart can help you figure out the difference between the two:
Works at a specific time and place set by you, the employer
Generally works for just one company
May receive training
Uses your tools or other work-related resources
Does work that is an integral part of your business
Is subject to a large degree of control by you
Is generally paid a salary or hourly wage
Why does it matter? Because employees…
Often receive employment benefits
Are subject to financial deductions such as income tax and Social Security tax, among others
May join a union
Are often protected by state and federal law for overtime and employment discrimination issues
An independent contractor:
Can work whenever and sometimes wherever they’d like
Can work for multiple companies
Usually trains on their own
Uses their own tools and resources
Controls their own method of work
Is often (but not always) paid by the project or on a flat-fee basis
Why does it matter? Because contractors…
Do not normally receive employment benefits
Pay their own self-employment tax and are not subject to other withholdings
May not join a union Generally do not receive overtime or protection for employment discrimination
However, these are not hard and fast rules. Other considerations also come into play when categorizing an employment relationship such as how permanent the relationship has been in the past and even how often the individual works for your company.
Still scratching your head? Don’t worry. Just fill out Form SS-8, and the IRS will do all the deciding for you.
Once you’ve classified your worker correctly, there are a number of differences in how you pay, tax, and structure working relationships with employees vs. contractors. Below is a quick breakdown:
|Employment Law||Covered by both federal and state employment laws Not covered by federal or state employment laws||Not covered by federal or state employment laws|
|Wages||Either an hourly rate or a salary paid, both paid on a regular schedule||As specified in the contract agreement|
|Paydays||Paydays must meet state payday laws||As specified in the contract agreement (e.g., one lump sum at the completion of work, smaller sums paid for milestones, etc.)|
|Tax Withholding||Withhold social security, Medicare, federal (and state/local, if applicable) income tax from each paycheck||Withhold nothing, unless you receive Notice CP2100 or CP2100A from the IRS (if the payee’s name and TIN on the information return filed does not match the IRS’s records)|
|Tax Documents||Employer must request a W-4 from each employee (and some states require additional withholding forms)||Employer must request a W-9 from each contractor|
|Tax Reporting||Reports all compensation paid to an employee during the tax year using a Form W-2||Reports payments of $600 or more in a calendar year using a Form 1099-MISC|
|Other Taxes||State and federal Unemployment Insurance||None|
For more information on the differences between employees and contractors, visit this IRS page.
Why is the distinction between employee and independent contractor important?
There are several reasons why it’s crucial to categorize your team properly:
1. The law (not you) dictates who’s an independent contractor and who’s an employee.
Did your employee sign a contractor agreement, an employment agreement, or do they just show up a few days a week to help out? No matter what your arrangement is, your team’s employment classification is ultimately based on the nature of the work they do and how they do it.
2. Employees and independent contractors are treated differently for tax purposes.
Companies are expected to pay certain taxes on behalf of their employees. This includes employment tax for the state and federal government, Social Security tax, and premiums for workers’ comp and disability. On the flip side, companies don’t need to pay these taxes for independent contractors. Instead, contractors are responsible for their own “self-employment tax.”
Missed the memo? Time to get things in order. Improperly classifying your workers could make you liable for back taxes.
Similarly, if you incorrectly categorize an independent contractor, they may be able to file an unemployment claim against you when their contract ends. Department of Labor requirements can also mean thousands of dollars in fines for accidental misclassification. Intentional or fraudulent misclassification of employees has led to hundreds of thousands of dollars in fines. No thank you.
3. Sometimes, independent contractors come with more liability.
You hear someone yell, “ouch!” around the corner. One of your employees just got hurt on the job, and you feel terrible. But if you correctly categorize them things probably won’t be so dire. How they’ll be able to recover often depends on their status, and in many cases, employees are the only ones who can receive workers’ compensation. Independent contractors, though, may be able to sue you under certain conditions, so make sure your workers’ comp policy is sealproof.
4. Employees are subject to different work expectations.
Some industries, like health care and education, are a jungle gym of rules and regulations that can have a real impact on your employees’ lives. This isn’t true across the employment spectrum, but if you’re in a highly specialized or professional industry, you may need to document additional rules surrounding the work your employees do.
What happens if I misclassify an employee as a contractor?
When hiring an employee can cost 25-30% more than hiring an independent contractor, it’s clear to see the benefit to employers. Government figures estimate 25-30% of all employees are misclassified as independent contractors.
And that is because, “generally, you must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to an employee. You do not generally have to withhold or pay any taxes on payments to independent contractors,” the IRS explains. Additionally, full-time employees are often entitled to health benefits.
But regardless of whether the misclassification was intentional or unintentional, your business could face serious legal and financial consequences for doing so. This could include reimbursement for unpaid wages, including overtime wages, paying the individual’s workers’ compensation benefits, retirement contributions, employee benefits, Medicare and Social Security contributions, unemployment insurance, health insurance, and any other employee-related costs like back taxes and any applicable penalties for state and federal income taxes. You may even be subject to a lawsuit in federal court, under certain circumstances. So just don’t do it.
When it comes to worker classification, the best thing you can do is be proactive, not reactive. Rather than waiting for a potentially precarious situation to occur, you should make it clear to your workers exactly how they will be classified from the start — and make sure their roles stay within the definitions provided by the IRS. It takes a bit of introspection and research to figure out how the two types compare, but once you get it down, your employee vs. independent contractor classification skills will put you at the top of your class.