When welcoming a new team member, you must be able to categorize them as employees or independent contractors. This way, you can ensure you remain in compliance with appropriate regulations.
In this guide, we explain the distinctions between an independent contractor and an employee and their significance in the business realm.
Key Takeaways
- While an independent contractor enjoys a higher level of flexibility, an employee is eligible for the benefits required by employment law.
- Independent contractors and employees are taxed differently using different tax forms.
- Misclassification of workers may be regarded as fraud and can have great repercussions.
- You can use corresponding agreements to establish clear terms and conditions for the employer and the worker.
What Is an Employee?
An employee is an individual who works under the supervision or control of an employer. The parties establish the employer-employee relationship with an employment contract. Employees can be either part-time or full-time and are eligible for various degrees of employee benefits.
What Is an Independent Contractor?
An independent contractor is an entity, either an individual (a freelancer) or a company, hired by an employer to complete specific projects and tasks defined in an independent contractor agreement. They are usually equipped with specialized skills or knowledge and enjoy the flexibility of working for multiple companies.
Independent Contractor vs. Employee: Employment Laws
Here’s a brief overview of the employment laws:
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Employees: Employees are subject to a comprehensive set of federal and state employment laws, including minimum wage, [1] overtime pay, [2] workplace safety, [3] and anti-discrimination laws. [4]
- Employers must comply with regulations like the Fair Labor Standards Act (FLSA) [5] and provide health insurance and paid leave benefits.
- Independent Contractors: Most employment laws governing traditional employees don’t cover independent contractors. They are considered self-employed individuals responsible for their compliance with tax and business regulations. [6]
The IRS’s New 2024 Worker Classification Rule
The US Department of Labor implemented a new rule in 2024 for classifying workers. It displaces the 2021 rule’s narrower scope, explaining that the classification of independent contractors and employees is subject to the “totality-of-circumstances” test. [7]
There are six factors that the Department of Labor evaluates to classify a worker:
Here are some examples of each factor:
| Factor | Employee Example | Independent Contractor Example |
|---|---|---|
| 1. Opportunity for profit and loss | A writer receives a regular salary from a publisher and gets assignments assigned to them. | A writer pitches topic ideas to various publications, negotiates contracts, and sets their own rates. |
| 2. Investments by the employer/worker | An IT support specialist operates entirely under a company's framework and doesn't purchase their own equipment to use for their job. | An IT support specialist maintains their own office space and buys advanced software and diagnostic tools. |
| 3. Work relationship permanence | A music teacher works for a music academy and plans to remain employed with no fixed end date. They don't actively seek out other students/clients. | A music teacher works with various clients and accepts teaching assignments depending on student availability. |
| 4. The nature and degree of control | A dietitian follows a hospital's protocols for creating diet plans and providing patient care. | A dietitian works outside the scope of a hospital and has more autonomy in their work. |
| 5. Whether the work is integral to the company's operations | A software developer maintains a company's core software programs and applications. | A software developer works on an application for a company, but the application isn't central to the business's operations. |
| 6. The skill/initiative involved | A photographer works for a magazine and executes their vision/goals. | A photographer uses their skills to attract and retain clients independently. |
Common Law Rules
Before 2020, hiring entities used the IRS 20-point checklist [8] to help determine independent contractor or employee status.
Now, the IRS has applied a less complicated approach to an independent contractor test [9] by distilling the 20-point checklist into three categories:
- Behavioral Control
- Financial Control
- Relationship
1. Behavioral Control
First, the IRS examines the degree of control an employer exerts over when, where, and how an employee works.
Employees:
- Hiring Practices: Employers control the hiring process and ensure employees receive adequate training. They implement specific job requirements and provide ongoing training to ensure employees meet their standards.
- Instructions: Employees receive detailed instructions on how to perform the assigned work and abide by company-specific processes.
- Supervision: Employees perform their work under the employer’s direct supervision. The employer monitors their performance, provides the necessary equipment, and sets work hours.
- Work Environment: Assessing an individual’s work environment can determine their employment status. In an employee-employer relationship, the employer dictates the employee’s environment.
- Reporting to Other Agencies: Employers must report new hires to state agencies for purposes such as child support enforcement.
Independent Contractors:
- Hiring Practices: Independent contractors seek their training using their time and money, and they’re responsible for developing their skills over time. Businesses hire contractors based on the skills they possess and their capability of performing a job without guidance or training.
- Instructions: Contractors can decide what processes and methods they’ll use to complete the assigned work.
- Supervision: A business engaging independent contractors lets them manage their own work and hours and have minimal supervision.
- Work Environment: Independent contractors maintain control over where they work, whether it be at a site of their choosing or their own office.
- Reporting to Other Agencies: There is typically no requirement for reporting the hiring of independent contractors to state agencies.
2. Financial Control
Next, the IRS considers how much responsibility the employer holds concerning the financial aspects of the worker’s job.
Employees:
- Wages: Employees receive a regular wage or salary. They receive payments in regular intervals, such as every week, two weeks, or month.
- Paydays: The employer sets the payday. They must withhold taxes, provide benefits, and abide by employment laws.
- Expenses: Employees don’t have business expenses. If they pay for anything out-of-pocket, they’ll receive a reimbursement from their employer.
- Profit and Loss: Employees can earn a salary regardless of the business’s performance.
Independent Contractors:
- Wages: An individual with independent contractor status sets their own rates and receives payment based on their contracts’ terms.
- Paydays: Independent contractors collect their own payments from clients and can control due dates.
- Expenses: Independent contractors must track and cover their business expenses for overhead, supplies, and tools.
- Profit and Loss: Client demand, the number of projects a contractor accepts, and other factors can influence a contractor’s income. In cases of fluctuating income, independent contractors may need to explore loan options tailored to their unique financial circumstances.
3. Type of Relationship
Regardless of what’s in the employment contract, the IRS determines a worker’s status based on how the employment relationship is actually carried out. If the worker is hired for an indefinite period of time, provides services that are a key business activity, and enjoys benefits, the worker is likely an employee in the eye of the IRS.
Employees:
- Value of Work: The work performed is integral to the company’s operations.
- Contracts: Employment contracts describe ongoing terms and a long-term commitment.
- Benefits: Employees receive benefits like paid leave, retirement plans, and health insurance from their employer.
Independent Contractors:
- Value of Work: Contractors perform tasks that aren’t central to the company’s main operations.
- Contracts: Contractor agreements last for a specific amount of time or encompass the scope of a specific project.
- Benefits: Contractors must buy their own workers’ compensation insurance and take care of their retirement on their own because they don’t receive traditional employee benefits.
Tax Obligations
Explore the tax obligations for employees and independent contractors:
Taxes and Tax Documents for Employees
- Tax Documents: Employers must withhold income taxes, Social Security, and Medicare taxes from employees’ wages. Employees receive a Form W-2 at the end of the year summarizing their earnings and tax withholdings.
- Payer’s Tax Reporting Requirements: Employers must report wages paid and taxes withheld to the IRS and Social Security Administration regularly. This involves filing various tax forms, including Form 941, for quarterly reporting.
Taxes and Tax Documents for Independent Contractors
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Tax Documents: Independent contractors are responsible for handling their own taxes. They receive a Form 1099-NEC from clients who paid them $600 or more during the tax year, but they are responsible for reporting their income and paying self-employment taxes.
- Note: Form 1099-NEC is not required if the independent contractor is a C- or S-corporation.
- Payer’s Tax Reporting Requirements: Payers must report payments of $600 or more to independent contractors by filing Form 1099-NEC. [10] However, quarterly reporting is generally not necessary.
For more detailed guidance on the tax implications of being a 1099 contractor versus forming an LLC, read our full article
Consequences of Misclassification
The government must collect its tax money to conduct its operations, so it relies on each business to correctly classify every member of its workforce. Misclassified workers can cost the government money and the business for the associated penalties.
Here are some potential consequences of misclassification:
- Back Taxes and Contributions: An employer may have to pay back taxes, such as Medicare, Social Security, and federal withholding taxes, that they should’ve withheld from the employer’s paycheck.
- Interest and Penalties: Employers may become responsible for penalties and interest charges if they pay taxes and make contributions late.
- Unpaid Wages: If an employer violates minimum wage laws or fails to pay an employee overtime, they may be responsible for distributing these wages.
Sometimes, the IRS can assess the situation and forgive employers when they think it was an honest mistake. Nevertheless, if the IRS deems the misclassification intentional, the misclassification is considered fraud, and the guilty party may face criminal prosecution and even jail time.
Consulting with legal and tax professionals is advisable to ensure compliance with relevant laws and regulations.
The Importance of Making the Proper Distinction
Understanding the difference between an independent contractor and an employee requires careful consideration, and both types of employment come with unique advantages and disadvantages.
Whatever relationship you choose for yourself or your workers, establishing terms and conditions in black and white is a crucial way to protect yourself and your business.
