Independent Contractor Guide: Definition, Legal Aspects & Benefits

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November 17, 2020
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In recent years, discussions are taking place, both in the US and worldwide, about independent contractors and their role in the gig economy. Multinational corporations around the globe are continually finding ways to reduce their worker-related expenses while tax authorities are scrambling to get the rights, benefits, and taxes of contractors in order.
In this article, we hope to give you a clear overview of independent contractors and shed light on their scope of work, rights, and obligations, as well as differences compared to employees.

What is an independent contractor?

An independent contractor is someone who supplies services or products to other entities as a non-employee. As a contractor, you have your own business and are in charge of paying taxes and benefits. Contractors are usually entrepreneurial spirits; they have either gained expertise in a field by working as an employee for a long time or someone wishing to break the confines of being an employee and be their own boss.
Independent contractors’ clients are not responsible for providing any type of employee benefits, but they also can’t control their work process. Independent contractor controls how long and in what way they perform the work, and the client has a say only in the final result. Contractors use their own equipment to do their job and are responsible for filing their income tax returns. The earnings of an independent contractor are subject to self-employment tax as an addition to federal income tax. A synonymous term for an independent contractor is a freelancer.

Before the digital age and the gig economy era, some professions were standard in the contractor book, such as dentists, lawyers, vets, doctors, and others classified as independent contractors by the Internal Revenue Service (IRS). Nowadays, however, the list of professions who can be freelancers or independent contractors has grown substantially to include designers, writers, artists, subcontractors, real estate agents, and many other categories of professionals.

The legal aspects of independent contractors

In the United States, a person needs to become a sole proprietor or establish a single-member limited liability company (LLC) to work as an independent contractor. Being self-employed and starting a business is universally praised in the US, especially if the value is created through innovative products and services. Still, self-employed professionals have some legal peculiarities that distinguish them from other business entities and regulate their rights and obligations.

First of all, independent contractors need to file their income on the 1040 Form along with quarterly submissions of their self-employment tax (SE tax). SE taxes are social security and Medicare taxes for the self-employed. These payments are usually submitted on a 1040-ES Form.
An important aspect of tax liability for contractors is that they don’t pay taxes on their gross income. Business expenses, where applicable, can substantially lower the tax obligations. For these business owners, tax is due on the net income, which is calculated as the difference between the gross income and deductible business expenses.

Since 2019, independent contractors pay a rate of 12.4% for social security taxes and 2.9% for Medicare taxes on the first $132,900 of their net income, with an additional 2.9% on their net income after those $132,900. Some freelance workers may also have to pay the state sales tax, depending on their business activity, but they don’t pay unemployment taxes.
As an independent contractor, keeping track of client payments and earnings is mandatory.

Clients working with independent contractors based in the United States need to obtain the Form W-9 or Request for Taxpayer Identification Number from their independent contractors. If the independent contractor is based outside of the United States, a From W-8BEN or W-8BEN-E needs to be submitted. Forms W-9 and W-8BEN(E) are necessary for issuing Form 1099-MISC if clients paid more than $600 for the services of the contractor within a tax year. Form 1099-MISC is standard for reporting non-employee compensation, and it covers the payments made to both independent contractors and freelancers.

Employees VS Independent Contractors: The Differences

The IRS uses several methods to determine whether a person is a regular employee or has independent contractor status. These methods align with the guidelines of the United States Supreme Court for distinguishing contractors from employees.

Degree of control over the work

Common law rules are in place to differentiate employees from contractors, and they do it based on the degree of control and independence. Control factors come in three categories:

  • Behavioral control means the employer or client has the right and possibility to control how the job is done. Keep in mind that this doesn’t have to mean they actually enforce the control over how you work - just that they can. By exercising control over the work process, we mean giving any instructions on using equipment, work location and hours, the order of tasks to perform the job, etc. The more control over the work process a client has, the less likely you are an independent contractor.

  • Financial control, which means controlling the business aspects of the worker’s job. If the business activity of the contractor requires significant investment into equipment, and they make that investment to be able to work for clients, it is likely they are independent. The opportunity to make a profit or loss, and the availability of the worker on the relevant market also come to play when determining independence.

  • Type of relationship, which illustrates the perception both sides have of the relationship. Written contracts don’t mean much to the IRS just because they state someone is an independent worker who pays their own taxes and benefits. The nature of the relationship and how the sides work together determines the relationship. Of course, any payments of employee benefits would indicate employee status, but other factors count as well. If a client is hiring a freelance worker for an indefinite period rather than a specific time frame, this would indicate an employer-employee relationship. The same goes for the type of services provided: if a contractor you hired is providing services crucial for your business, they are more likely to be employees.

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Rights and protections: Employees VS Independent contractors

As an employee, whether part-time or full-time, the employer has the right to control virtually all aspects of the work: the working hours, workplace location, equipment, and technology use, as well as the workflow and process. In exchange for this control, an employee gets rewarded not just with job and income stability, but other perks and benefits too.
Employers commit to paying employee's health insurance, potentially sponsor a pension plan, provide sick leave, and paid time off. US Labor Law is designed to protect the employees. However, none of these benefits are available for contractors - they have to pay for them independently. Contractors also don’t get access to unemployment insurance, worker’s compensation benefits, or other expenses mandated in the employment laws.

While employees pay FICA taxes, commonly known as payroll taxes, independent contractors pay the self-employment taxes we have already mentioned above.

Finally, because employees work for employers regularly, they are entitled to receive the benefits stated in the Fair Labor Standards Act, such as minimum wage. Contractors, on the other hand, charge their products and services based on market fees.  

Misclassification risks

Being an independent contractor essentially means being your own boss. However, big companies will sometimes try and lower their duties towards employees by signing an independent contractor agreement instead of employing them full-time. If you find yourself in a situation where your small business depends on a single client for survival, you have potentially entered the misclassification zone.
The IRS and the US Department of Labor have made worker classification their priority in recent years, establishing tests for determining the worker’s status correctly, such as the 20 Factor Test.

Misclassifying an employee as an independent contractor is risky and potentially expensive for businesses, as it may impose large fines, fees, and reimbursements for the workers. Many workers are fighting battles in this arena, Uber drivers for example, who won a lawsuit against their employer who wasn’t abiding by the tax laws.

Determining the employment status is possible through filing Form SS-8. When this form is filed, the IRS can ask the employer to pay back the employment taxes and penalties and interest, which can turn out to be quite a sum.
There is a unique, third worker classification that lies between employees and independent contractors: statutory employees. They can be traveling salespeople, life insurance salespeople, commission drivers, or home workers. They are treated as employees for federal income tax purposes even though by common law, they are independent contractors.  

Benefits of hiring independent contractors

A company should carefully consider whether hiring contractors makes sense and ensure compliance with (local) laws and regulations. There are, however, unquestionable benefits to working with independent contractors such as:

Staffing flexibility

Because contractors are usually hired to work on a specific project or fill a short-term need, fluctuating workload won’t be an issue. Companies don’t have to worry about looking for an employee who won’t have anything to work on after completing a project - a freelance worker can be contracted to do the job.

Global talent pool

When hiring independent contractors, a company is not tied to any local talent pools. Contractors don’t work at the company's premises, meaning they can work from anywhere in the world. A company may find out that the perfect designer for that brochure project is located halfway around the globe. If the company is hiring them as a freelancer, nothing is stopping the fruition of an international business relationship.

Minimal training required

Freelancers are usually highly specialized in their field of expertise, and they will require little or no training to perform the tasks. Choosing from a global talent pool grants access to highly skilled and specialized professionals who can start working the moment they are hired.

Cost savings

Even when counting in the fees of contractors, which are usually more expensive than employees’ hourly rates, employees cost more money to the company. Clients who work with contractors do not cover traditional benefits, and the freelance workers pay their own taxes, which makes hiring contractors very cost-effective.

Ease of ending a business relationship

Employees have rights warranted by the Labor law and are therefore much more protected from termination. Ending a business relationship with a contractor is as easy as not renewing a contract. Additionally, a company can set its own termination terms in the contractual agreement. This enables companies to look for experts who will offer their skills at a competitive rate and maintain a high standard of client satisfaction.

Why independent contractors are good for the economy

Independent contractors are important economic players - they are entrepreneurs, risk-takers, and innovators. They start new companies, create value and jobs by growing them and make the overall market more competitive and diverse. Using the goods and services provided by contractors can benefit many companies by enabling them to focus on their core work and leave their other needs to experts.
Even though the spotlight in the contractor story has shifted to corporations misclassifying workers, we shouldn’t forget that freelancers are a crucial part of every economy.
We need independent contractors and their skills, and we should help them thrive by hiring them whenever the need arises, paying them fairly, and advancing their growth prospects.

If you are considering hiring independent contractors for your business, Deel can help you streamline the onboarding process by offering you localized contracts, tax form collection, and the best payment experience for both you and the contractors. Schedule a product tour with a specialist to learn more.

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