Independent Contractor vs. Employee: What's the Difference
Every employer needs to be aware of how their hiring choices can influence their business. Knowing the difference between a full-time employee and an independent contractor isn’t always easy to determine, but it's critical not to make a mistake because, when it comes to taxes and the IRS, that difference carries a lot of weight.
In this article, we'll explain in what aspects employees and independent contractors differ and how you can accurately identify which category your workers belong to. Before we get into details, take a look at this streamlined summary of the primary differences between these two types of work.
What is an employee?
Employees, whether or not they are full or part-time, office-based or remote, are workers under your direct supervision and control.
The main characteristics of employees are:
- They have a manager
- They have working hours or a schedule
- They have an office space
- They use company equipment
- They can enjoy benefits such as vacation pay, contributions for pension plans, private health insurance, etc.
Employer responsibilities and gains
Let's start with what an employer gains by deciding to work with employees. The biggest benefit for the employer is the amount of oversight. The control test will also help you determine the nature of the employer-employee relationship. Employers can count on their employees since they determine their scope of work, particular projects, and assignments, hardware and software, deadlines, and methods of working.
In addition to this, the employer is the one that determines schedules, shifts, working hours, vacations, and holidays. They can decide who to hire and fire, determine team structure, promotions, office space and location, and daily routines and organization.
This level of control and supervision is comes with additional employer costs that come with every employee. The employer is responsible for paying several employment and payroll taxes for each worker.
For US employers, they are responsible for calculating federal income tax withholding, which they deduct from the employees' wages. This is followed by Social Security Tax and Medicare Taxes. Finally, the employer pays FUTA, which is the federal unemployment tax. FUTA taxes are an additional employer cost; the amount does not come out of workers’ compensation. In addition to this, employees are guaranteed minimum wage, are protected by labor laws, and have workers' compensation insurance.
At the end of the tax year, the business owner files a Form W-2 for every employee. The W-2 form is a record of how much the employee made over the year. Employees may be referred to as "W2 employees".
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What is an independent contractor?
On the other end of the spectrum, you have independent contractors (or freelancers) who have a different working relationship with those who they provide services for. They are basically self-employed individuals, and their methods of working and the taxes they pay are much different in comparison to employees.
Contractors usually have an entrepreneurial spirit, and sometimes even become small business owners after a few years. They are self-motivated, proactive, and well-organized. Their training, development, and skills are their responsibility. They provide their own tools and equipment. In order to start their business, they require what the IRS calls "significant investment", and they can't rely on employers to provide them with it. There are no strict rules about the type of work they can do.
However, they do lack specific protections that full-time employees get to enjoy. For example, they don't have any protection in case they get sick - in these situations, they simply don't work, which means less money for them, since they don't have a fixed salary or paid time off.
Common independent contractor jobs are:
- Social media managers
- Customer support agents
Employer responsibilities and gains
When an employer hires an independent contractor, they aren't obligated to pay any employee benefits or employment taxes, like they are with their own employees. They create a short-term, written contract where they outline all of the necessary conditions of their cooperation, such as compensation, deadlines, and payment methods. Employers only have the obligation of paying the previously agreed upon fee to the freelancer.
When it comes to their obligation towards the state, they are required to file Form 1099-NEC (previously known as Form 1099-MISC), for each independent contractor you pay $600 to or more during a tax year.
Of course, there are still tax forms to file, just in this case by the independent contractor. They are subject to self-employment taxes, as well as income taxes. The SE tax covers social security and Medicare (FICA).
As you can see, since an independent contractor is the taxpayer when it comes to their income, healthcare, and other responsibilities, they may be a more affordable option for many employers. However, they need to be careful not to overstep the line between contractors and employees.
How does the IRS classify workers?
The Internal Revenue Service doesn’t have a strict set of rules that determine the employee’s status, which poses a challenge for every employer.
However, they have a list of guidelines that help them decide every particular case, specifically for tax purposes. In their eyes, every person hired is viewed as an employee. That means that the employer is responsible for providing all sorts of benefits, such as healthcare, and paying all the necessary taxes. That gives them the right to control hours, office space, and employee’s schedules.
When it comes to independent contractors, the situation is the opposite. Independent contractors have the right to control and choose the conditions and don’t depend on the employer in any way. They are responsible for filing taxes and taking care of their own hours, health insurance, vacation, and other contributions. They may not qualify for unemployment insurance. The easiest way to understand it is that a higher degree of control comes with more significant responsibilities and taxes.
The issue of worker misclassification under the employment law is a very serious one because it can be considered tax evasion. If a company intentionally tries to classify their full-time workers as independent contractors, this can be viewed as fraud because the company enjoys maintaining a high degree of control over their employees but get to avoid paying the taxes that accompany this type of employment. Since the amount lost is far from little, misclassifying an employee as a contractor is taken very seriously by the government, such as the state government, the IRS, and the U.S. Department of Labor.
It's important to note that there is no difference between big or small businesses when it comes to these issues. The same rules and regulations apply and agencies are well-equipped to launch thorough audits if your business comes under scrutiny. The consequences of failing to properly classify a worker include financial penalties on top of having to pay all of the back taxes for every misclassified worker.
Worker classification: 3 IRS tests
There isn't a simple formula you can apply to determine whether someone is a full-time employee or an independent contractor. Instead, the IRS uses three broad criteria to assess the employment relationship - behavioral control, financial control, and type of relationship.
Under the Fair Labor Standards Act, these questions are fundamental to determining the nature of the relationship, and the subsequent classification and tax liability that goes with it.
1. Behavioral control
If the employer has the right to instruct how the work is done, this is a sign of an employee.
Examples of behavioral control include:
- Hours and schedules: does the employer direct when the worker should work?
- Place of work: does the employer control where the worker should be?
- Methods and tools used for work: does the employer instruct how something should be done? Providing training is strong evidence of an employee relationship.
There are many benefits to hiring freelancers, but this isn't one of them. If you want to be in charge of the entire process, you shouldn't choose to work with a contractor.
2. Financial control
Financial control looks at how much an employer controls the worker's financial and business aspects of the job. Employees are guaranteed a set salary or wage, and receive employee benefits. Employees are also often reimbursed for fuel, tools, office supplies, licenses, and other business expenses. They almost exclusively work for one employer, especially if they work full-time.
This isn't the case with independent contractors. Independent contractors generally pay out of their own pocket for materials, software, or resources. They are paid a flat fee for the services they provide. They can, of course, have more than one client, and they can incur a profit or loss, just like any other small business.
3. Type of relationship
The type of relationship between worker and employer can affect the employment status. If a person you hired is providing you with a service that is essential or integral to your business, they are likely to considered an employee.
The idea behind this is that workers that are responsible for the core business should enjoy all the benefits, such as health insurance and sick days, that the law provides them with. That means that cooks in a restaurant, hairdressers in a salon, and account managers in a digital marketing agency can't be outsourced. But if you hire an account manager to create a marketing strategy for your restaurant, they'll likely have an independent contractor status.
Another factor is the permanency of the relationship. Freelancers and contractors are usually hired on a short-term basis, for specific projects, periods of time. Any long-term relationship, especially if the scope of work is essential to the business, is considered an employee.
Other classification tests
Another way to determine employee status is the common law twenty-factor test. This test is no longer officially used, but it has a number of guiding questions that can still be useful in your determination.
If you and your accountant are still unsure of a worker's classification, you can ask the IRS to step in and determine the business relationship by completing Form SS-8 (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding). It may take at least six months to review your case. A worker who believes they are incorrectly classified can submit a SS-8 too.
Is it better to be an employee or contractor?
There is no definite response to this question since it entails knowing everyone's preferred way of working, values, and priorities. Undoubtedly, there have been more and more remote contractors lately. Technology has helped many jobs to be able to be done remotely, and the flexible ability to set your own hours has become increasingly important to people everywhere.
Certainly, working as an independent contractor has a lot of benefits. The most important one is certainly freedom that allows you to set your own schedule and ways of working vacation days, tools, and projects. The ability to choose your own clients is a very valuable benefit of freelance work.
On the other side of the coin are the certainties and employment benefits of full-time employment status. Although that stability has been shaken in 2020, the market is slowly returning to its usual pace. Working in a company that contributes to the world in a positive way and foster a culture of inclusion, diversity, and acceptance can be a great choice for many.