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. Misclassification is a serious problem for workers, who could be denied workplace legal protections and benefits if misclassified. Misclassifications are also problematic for employers, who could face fines and lawsuits.
How to tell the difference between an independent contractor and an employee
An independent contractor is a worker who often owns their own business and usually enters into contracts with employers to perform a specific project, typically on a short-term basis. In contrast, employees agree to work on a regular basis for a single employer. In some situations, the line between an independent contractor and employee is pretty clear. For instance, if you contract with an IT professional to set up your business’s new computer network, this person would probably be an independent contractor. In other situations, the line can be fuzzy. Say you are bringing on a temporary worker to help cover a big project that your business has been working on for a few months. This person could be considered an employee, but the classification of employee versus contractor would depend on several factors.
The IRS, the Fair Labor Standards Act, and the common law have all helped define the differences between an employee and an independent contractor. Although there is no single test to determine independent contractor status, these tests share some common characteristics. For example, they all analyze the degree of control the company has over the worker and afford little weight to how the parties’ themselves characterize the relationship. So, if the relationship between your company and a worker looks like an employer – employee relationship, then it probably is! Even if you intended for them to be a contractor.
To determine whether a worker is an employee for federal tax classification purposes, the IRS looks at three defining areas: behavioral control, financial control, and the type of relationship.
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. The work must be performed by a particular person; employees don’t generally have the authority to hire someone to assist them. Also, if a company’s evaluation system measures the details of how work is performed, it suggests an employment relationship.
Conversely, contractors have much more control over the circumstances of their work. They determine when and where they will work, and they use their own tools (e.g. consultants will have their own laptops, roofers come with their own hammers). Contractors generally have the authority to retain or hire their own employees to do the work. Finally, a company’s evaluation system for an independent contractor should measure the end result only.
Financial Control: Employees are paid an hourly or salary wage set by the employer. Taxes withheld from their payments and paydays are set up on regular intervals—generally bi-weekly or monthly. Employees do not invoice their employers.
Unlike employees, contractors have invested in their own business, for example by paying their own expenses. Because of this, they have a financial stake in its success. Additionally, contractors’ payment terms can vary. Unlike salaried employees, contractors usually 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. Businesses do not withhold taxes when they pay a contractor’s bill.
Relationship: Employees can expect to perform work that is essential to the business and for the relationship to continue indefinitely. If you own a restaurant, your cooks are likely part-time or full-time employees. After all, you need people who will prepare the food in order to be open for business!
Contractors 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 as stated above, the line can 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
- Receives 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 employee benefits, like health insurance and paid time off
- Are subject to financial deductions such as income tax and Social Security tax, among others
- May join a union
- Are protected by state and federal laws for overtime, minimum wage, and employment discrimination
An independent contractor:
- Can work whenever and sometimes wherever they’d like
- Can work for multiple companies simultaneously or in the same year
- Is not trained by the employer, rather are hired for their expertise
- 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 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
These guidelines can help you to determine whether you need an employee or an independent contractor, 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 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.
If you are still unsure about how your workers should be classified or you have a particularly complicated situation, reach out to a wage and hour attorney for advice.
Still scratching your head? You can file a Form SS-8 with the IRS.This 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. Once the form is filed, the IRS will investigate and issue a determination letting you know if the worker is an employee or a contractor.
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?
Individual workers often choose to become contractors because they desire greater control over their work environment and schedules. Companies often choose to use contractors to reduce costs when they only need someone for one project. While it can be beneficial for both parties, independent contractor misclassification results in exposure to liability in several areas. There are several reasons why it’s crucial to categorize your workers properly:
1. Misclassified workers miss out on employee benefits and protections.
If a worker does not enter the employment relationship with the intention of being an independent contractor, they probably want to receive retirement benefits, health insurance, and paid vacations that are available to employees. Misclassified workers also miss out on legal protections that are afforded to employees, such as wage and hour laws, workers compensation, and unemployment benefits.
2. 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, or what your written agreement says, your team’s employment classification is ultimately based on the nature of the work they do and how they do it.
Simply referring to a worker as an independent contractor, even in a written agreement, does not prevent legal challenges to that classification by workers, the Department of Labor, the IRS, or state or local authorities. Misclassification audits and lawsuits are common and can result in steep costs and penalties.
3. 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 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, one implication is that 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.
4. 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 even though contractors should have their own insurance policy, it’s best practice to make sure your workers’ comp policy covers anyone who is working for you, regardless of classification.
5. Employees can be subject to different workplace regulations.
Some industries, like health care and education, are a jungle gym of rules and regulations that specifically apply to employees. This isn’t true across the employment spectrum, but if you’re in a highly regulated industry, you may need to conduct additional trainings and retain additional documentation surrounding the work your employees do.
What happens if I misclassify an employee as a contractor?
When hiring an employee can cost up to 30% more than hiring an independent contractor, it may be tempting to try to classify your workers as independent contractors. But unless they truly are an independent contractor, it’s not worth the potential savings. Government figures estimate 25-30% of all employees are misclassified as independent contractors. It’s crucial that employers get this right.
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 and Department of Labor.
This post was originally published on December 20, 2016.
This post was updated on November 30, 2022.