If you’re bringing on a new hire, you’ll need to classify them as either an employee or an independent contractor. We’ll walk you through the differences between an independent contractor versus an employee and why they matter.
How to tell the difference between an independent contractor vs. employee
The IRS looks at three defining areas:
Behavioral control: Employees typically work specific hours as directed by their employer, and at a location that is determined by the employer. They use the company’s tools and resources to perform their job.
Contractors specify their availability; they tend to communicate when and where they will work, and they often use their own tools (e.g. consultants will have their own laptops, roofers come with their own hammers).
Financial Control: Employees are paid an hourly or salary wage. Taxes withheld from their payments and payday is set by the employer. Employees do not invoice their employers.
Contractors are likely to have invested in their own business, and they have a financial stake in its success. Their payment terms can vary. Unlike salaried employees, contractors tend to invoice for time and/or deliverables. For example, they may charge hourly or project-based fees with half to be paid upfront and half to be paid 30 days after the project has been completed and an invoice has been sent. Retainers are also common for contractors who address needs on a regular basis and require advance payment. Clients typically do not withhold taxes when they pay a contractor’s bill.
Relationship: Employees can expect to perform work that is essential to the business. If you own a restaurant, your cooks are likely part-time or full-time employees. After all, you do need people who will prepare the food in order to be open for business!
Contractors tend to perform short term, specialized functions. For instance, you might hire a grant writer to help your non-profit to apply for a specific grant opportunity, or an interior designer to decorate your office space. When in doubt, 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, like health care and paid time off
- 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, minimum wage, 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 taxes 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. Someone who uses a company laptop and works flexible hours from the location of their choosing for an average of 40 hours per week on-going is still likely to be considered an employee, even though their schedule and location are flexible. Many considerations 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, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, and the IRS will let you know if your worker is an employee or a contractor. The form can be filled out by the employer or the worker, and we have a dedicated blog post to walk you through how to fill out Form SS-8.
How your worker is classified makes a difference in how you pay, tax, and structure your working relationships.Below is a quick breakdown:
|Employment Law||Covered by both federal and 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-NEC—unless the contractor has a corporate business structure, in which case the 1099-NEC is not required|
|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 taxes.
Missed the memo? Time to get things in order. Improperly classifying your workers could make you liable for back taxes.
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 significant 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 covers anyone who is working for you, regardless of classification.
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 employer benefit to hiring independent contractors. Government figures estimate 25-30% of all employees are misclassified as independent contractors.
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.
This post was originally published on December 20, 2016.
This post was updated on November 1, 2019.