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What is the Difference between an Employee and an Independent Contractor?

Last revision:
Last revision: May 12, 2019
Last revision:
Category: Employment Contracts

Many companies in India are looking at new ways to optimise the efficiency of the work force rather than stick to the traditional model of employment. In this respect, independent contractors have become a common used workforce with many businesses choosing to create teams and carry out tasks using both employees and contractors.

It is important to know what is the difference between the two and what are the advantages or disadvantages of having one over the other. The same would depend on a case to case basis and large businesses who require permanent workers involved in important areas of the business, may need employees as independent contractors may not be able to fulfill the requirements of the job. On the other hand for a company engaged in agricultural business looking to hire a temporary worker on a seasonal basis an independent contractor may be a better choice.

The biggest thing to remember in setting up any working relationship is that it's illegal to intentionally miscategorize a worker. In other words, it's not legal to retain a worker for a long-term period who is actually working as an employee but then categorise him as a contract worker and fail to pay employment benefits which are due to regular employees.

Indian courts through precedents have made a distinction between contracts of service and contracts for service. Basically, a contract of service applies to an employee-employer relationship, while a contract for service applies in the case of an independent sub-contractor. Here, we'll discuss the significant differences between employees and independent contractors and help you figure out exactly which work structure is right for your business.

Who is an employee?

An employee is a person who enters into a contract of service with the employer. In a contract of service the employer has control over the work of the employee and the employee is bound to follow the instructions of the employer. For instance, an employer can specify working hours and number of holidays that can be taken by an employee. An employer has the final say in the tasks that are being carried out by an employee.

Who is an independent contractor?

An independent contractor, on the other hand, is a person who enters into a contract for service with a client. An independent contractor undertakes to produce the required result, but he is not under the order or control of the person for whom he executes that work and is free to use his discretion. Independent contractors have more independence than employees and may provide services to more than one person/ entity as well as set their own working hours and holidays.

An independent contractor is a person who runs his/her own business as an independent entity, whereas an employee is an individual hired by the company to work under the instructions of the company on specific tasks. Independent contractors determine their own working hours, openly market their services, raise their invoices and are usually engaged for a limited time period or specific project, whereas employees work for a single employer who determines the working hours. Further, often independent contractors are permitted to sub-contract or delegate all or part of the work to be performed by them, as against employees who do not have this level of independence.

Why is it important to identify whether a person is an employee or contractor?

Difference in tax treatment

Salary paid to an employee may include benefits and allowances that the employee is entitled to. Employers are required to deduct the tax payable at source from the salary being paid. In case of independent contractors, the amount to be deducted as tax is different and usually lower since the independent contractor is required to pay his taxes after accounting for business expenses.

Entitlement to benefits

An independent contractor is not entitled to benefits which are given to employees pursuant to various provisions of central and state laws such as provident fund, pension fund, insurance schemes, employee state insurance, workman's compensation, gratuity, bonus, maternity benefit, leaves and holidays.

Restrictions on use of contractors

There may be some restrictions on the use of independent contractors in certain cases. In some cases, it is prohibited to engage contract labour for certain jobs. The Contract Labour Regulation Act prohibits employment of contract labour in certain instances and sets out that the Central/State government may prohibit employment of contract labour in any process, operation or other work in any establishment by notification in the official gazette. Accordingly, the Central/ State government have issued some notifications for sectors such as mining, refineries, etc.

Factors that determine who is an employee and who is a contractor

Courts in India have applied various tests to determine whether a person falls under the definition of an 'employee' or a 'contractor'. One such test being the 'control test' which provides that where a person not only directs the work to be done but also controls the manner in which the work is to be done - such person would be considered an employer and the person carrying out the work would be an employee. The nature and extent of control may differ in different industries.

In Dhrangadhra Chemical Works Ltd. v. State of Saurashtra (AIR 1957 SC 264), the Supreme Court held that the test of supervision and control can be taken as prima facie test for determining the relationship of employment. In other words, if a person controls the manner in which the work is to be done by another person, the first person is presumed to be an employer of the second person. The greater the amount of direct control exercised over the persons rendering services by the persons contracting for them, the stronger would be the presumption for holding it to an employer-employee relationship. However, this is a presumption, and it can be reversed if other factors prove the worker is in fact an independent contractor.

Another test which is often used is the 'integration test'. In this case, it is seen to what extent a person is integrated into the employer's business or remains independent of it. Under a contract of service, a person is employed as part of the business, whereas under a contract for service, his work, though done for the business, is not integrated into it, but only accessory to it.

Various facts and circumstances must be considered prior to making a determination regarding the status of a person including the extent of control and supervision, duration of engagement, economic control, nature of work to be done, right to appoint and dismiss etc.

Is an agreement with an independent contractor necessary?

A legally binding agreement with a contractor such as a Service Agreement should be entered to avoid misunderstandings at a later date. However, such an agreement should be used only while obtaining services from an independent contractor or consultant. In case of hiring an employee an offer letter for employment or employment contract should be used. If you are a business or a worker and have any concerns about these matters, seek legal advice.

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