What's the Difference Between an Employee and an Independent Contractor?

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Work culture in the United States has been rapidly changing over the past several years. Because of this, many companies are choosing to create a workforce based on what works for them, rather than the traditional model of employment. In this respect, independent contractors have been a growing segment of the workforce, with many businesses choosing to create a team based on multiple different working relationships: employees and contractors alike.

If you're a small- to medium-sized business thinking about hiring any independent contractors, it's important to know exactly what the differences between contractors and employees are. Knowing how to structure your working relationships ahead of time will help avoid any headaches down the line, either from the Internal Revenue Service (IRS) or your own internal record keeping.

It's important to keep in mind that often, the structure of the relationship is decided for you. For example, for a large business looking to hire a worker that will be permanent, involved in important areas of the business, and paid on a regular schedule, there's no choice but to hire an employee. For a structure like that, an independent contractor relationship wouldn't work. Similarly, for a construction business looking to hire a temporary worker that only gets paid once in a lump sum with no benefits and no permanency, there's no choice but to hire a contractor.

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 that looks a lot like an employee but then fail to pay workers' compensation, for example.

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.

What defines an employee?

Legally, one of the most defining characteristics of any employee is someone that falls under federal labor laws and is eligible for workers' compensation at the state level. Mostly, companies choose to hire employees because they are looking for a long-term, mutually beneficial relationship whereby the employee can grow with the company, work on key aspects of the company's business, and in return, get a regular wage and benefits. Employees often have at least some degree of job security and long-term growth potential.

What defines an independent contractor?

Contractors control their work: everything from what they do to how they are paid. Instead of an employee, a company might choose to hire an independent contractor because they need a specific task done, or they need work done for a limited period of time that is not key to the company's business. An independent contractor might choose this type of work in order to have more freedom over their work.

Why does it matter?

The differences between independent contractors and employees matter a lot for your business! Here are the three main reasons to ensure that you have a proper understanding of all of your working relationships:

1. Tax liability

Whether or not a worker is an employee will determine the potential employer's tax liability - or lack thereof. For employee workers, employers are subject to paying unemployment taxes to the state and federal governments. Additionally, social security tax must be paid to the IRS. Finally, funds for workers' compensation get paid to the relevant state.

If a worker is not an employee and instead is a contractor, none of these payments are due.

Incorrectly categorizing a worker could result in back taxes and penalties.

2. The application of federal employment and labor laws

Employees alone may be eligible to file unemployment claims - independent contractors are not. Additionally, federal labor laws, like the Fair Labor Standards Act, cover employees only and do not extend to independent contractors.

Regardless, however, it is always advised to provide fair and safe working conditions and wages for all workers, not just employees.

3. State unemployment insurance and workers' compensation

For their employees, employers must pay into state unemployment just like federal employment. Additionally, employers must pay into state insurance funds for workers' compensation and disability.

For independent contractors, these payments do not need to be made.

What questions can you ask generally to determine the relationship?

The IRS has provided guidance.

In order to generally determine what type of relationship you might have with your worker, there are three main factors to consider. The IRS itself has provided some guidelines to help businesses determine whether they should properly treat a specified worker as an employee or independent contractor. (Additional details can be found at IRS.gov.)

1. Does the company exert behavioral control over the worker?

First, the IRS looks to whether the company that has hired the worker exhibits general behavioral control. Essentially, the IRS is looking to see who controls the logistical elements of the work and the structure of the work. Specifically, consider whether your company controls when and where work is done, what tools and supplies are used, and where to purchase those tools and supplies. It's also important to consider what type of instructions the worker receives, including the level of detail of those instructions. For example, perhaps the worker receives almost no instructions and just needs to complete a task however they would like. This would indicate more of an independent contractor relationship than an employment one.

Another factor that the IRS considers in this category is how the work is evaluated. For example, if the worker can be evaluated on how the work is done or the details of how it's done, that looks more like an employment relationship. If, on the other hand, the worker is just evaluated on whether the work was completed, that's more of an independent contractor relationship.

Finally, within this category, the IRS looks at whether the worker was trained by the company. Any type of training generally suggests an employment relationship.

2. Does the company exert financial control over the worker?

Closely related to behavioral control, the IRS also looks to see whether the company exerts financial control over the worker. Financial control basically means that the company is in charge of how and when the worker gets paid, including whether they are reimbursed for expenses.

In the case of an employee relationship, the employee would be paid on a regular schedule, like weekly or bi-weekly, and would always earn a generally set wage. The wage can be hourly or an annual salary or it can even be commission-based. The important thing here is that the employee gets paid on a regular schedule and the company controls how they are paid. Most often, employees are reimbursed for any expenses incurred for the company.

With an independent contractor, by contrast, the company exerts almost no financial control. In that case, the contractor generally covers all of their own expenses without getting reimbursed and gets paid only when they submit an invoice. Contractors are most often paid a flat fee, but they can also be paid according to a different fee arrangement, like hourly. The big difference to note here is that even if contractors are paid by the hour or by the day, they don't get paid unless they submit an invoice, unlike employees who get paid on a regular schedule by their company. Usually, contractors have their own tools and equipment that they use for all of their jobs and they're allowed to market themselves wherever they would like. Contractors may even make a loss on some jobs, if their expenses outweigh their fees.

Be advised, however, that if a worker classified as an independent contractor receives most or even all of their income from a "contract" job, it's likely that they will be considered an employee by any courts which may have a look at the issue and by the IRS.

3. How do the parties view their relationship?

The final major factor that IRS looks at to determine whether a worker is an employee or independent contractor is the overall structure of the relationship between the parties.

The IRS asks the following questions:

  • Is there a written contract evidencing the relationship?

Although a written contract is not the final say on the relationship, it is one factor that the IRS considers. Be aware, however, that you should never draft an agreement to say a worker is an independent contractor when they are really an employee. Always be truthful in your employment dealings and ensure that the contract you have, if you have a written contract, properly describes the working relationship. You could otherwise be subject to back taxes and other penalties.

Note that in independent contractor relationships, there are a variety of agreements that can be used. In this case, an Independent Contractor Agreement may be used, but the parties can also decide to use a Service Agreement, a Freelance Agreement, or any other type of specific, project-based agreement (examples include a Graphic Design Agreement for graphic designers and a Virtual Assistant Agreement for online help).

  • Does the worker receive employment-type benefits?

If the worker receives benefits like insurance, vacation pay, sick pay, or any long-term financial planning, the IRS is much more likely to view that as an employment relationship. Contractors generally don't receive these types of benefits.

  • Is the relationship meant to continue indefinitely?

If the parties expect that the relationship will generally continue without a set end-date or time, this is most likely an employment relationship. Contractors are usually only hired for a specific project or limited time period.

  • Are the services provided by the worker a key aspect of the company's business?

Employees generally provide services that are very important, or core, parts of the company's business. Contractors are most often brought out to do simple tasks, rather than those that make a big difference to the company's core business.

The key differences

The key differences between employees and independent contractors can be summarized as follows:

1. Independent contractors fully control themselves and their business.

As discussed above, independent contractors have the full ability to control how they work, how they get tasks done, what tools they use, and almost all other elements of their business. Employees, on the other hand, generally have to report to work as their employer requires and can be subject to detailed instructions on their work and how they do it.

2. Independent contractors fully control their payment.

Independent contractors will generally get paid either once in a lump sum or through an invoicing system. They do not get paid on a regular schedule that their company sets. They fully control how they take payment and if any late fees are due for lack of payment or late payment. Employees, on the other hand, do get paid on a set schedule determined exactly by their company, including how payments are made.

3. Independent contractors get no benefits.

Independent contractors do not receive any benefits like unemployment, long-term pension plans, or paid vacation or sick days. Employees, in contrast, generally receive all of these benefits.

4. Employees are generally hired for an indefinite term.

In an employment relationship, the length of time that the employee will be working for the employer is usually indefinite because the relationship is meant to grow. For contractors, it's the opposite: contractors are hired for a limited time or a specific task.

5. Taxes are not withheld for independent contractors.

Employers are responsible for withholding taxes from their employees' paychecks. For contractors, that is not the case, with contractors being entirely responsible for their own tax liabilities.

6. Independent contractors can openly market their services.

Independent contractors are permitted to openly advertise their services anywhere they see fit and to take on new clients whenever they would like. In contrast, many employees are limited by some kind of Non-Compete Agreement or provision or even sometimes just required to devote the majority of time to their regular job.

7. Employees are paid regular wages on a regular schedule.

Employees make regular income at regular intervals. Most often, employees are paid paychecks every week to two weeks and they can generally rely on what will be contained within that paycheck. Independent contractors, on the other hand, are usually paid by the job, though they may be paid in another way, as well. Regardless, contractors do not have a regular paycheck and may even face a business loss if they don't allocate funds properly.

8. Independent contractors may be able to subcontract out the work.

Independent contractors are generally able to hire others, called sub-contractors, to assist with their work or do their work for them. Their clients do not control this feature of the relationship. Employees, on the other hand, are required to do the work they are assigned to do, either by virtue of their employment position or by their supervisor.

9. Independent contractors generally use their own equipment.

Independent contractors can use their own equipment and tools. Usually, these equipment and tools go with them on all of their jobs. Employees, on the other hand, are restricted to equipment and tools owned by their employer and most are required to work in an office or at a specific location.

10. Employees generally perform key aspects of the company's business.

While contractors are most often hired to complete one or two discrete tasks, employees are constantly involved in the day-to-day core business of the company. Usually, employees are specifically hired for one position that covers significant elements of the employer's business.

As you can see, there are many different ways to really understand the differences between employees and independent contractors. Your business might be best suited for just one of these types, or you may wish to develop a workforce that makes use of both. Either way, making sure you know how to distinguish between the two is a great first step in deciding how to grow your business.


About the Author: Anjali Nowakowski is a Legal Templates Programmer at Wonder.Legal and is based in the U.S.A.

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