Do you know what FedEx, Uber, and Microsoft have in common?
Your answer might concern their global prominence, large scales, or high profits, but it probably wouldn’t include verdicts of employee misclassification. These multinational companies had been sued either by the federal government or the “freelancers” working for them, and they had paid a high price (literally) due to wrongful worker classification.
To avoid such consequences and maintain your status as a well-behaved, honest citizen—whether you are a business owner or a freelance worker—continue reading to understand the difference between an independent contractor and an employee.
Employment Status
What is an employee?
An employee is an individual who “works under the supervision or control of an employer,” and the employer-employee relationship is usually established by an employment contract. Employees can be either part-time or full-time and are eligible for employee benefits in various degrees.
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 potentially working for multiple companies.
9 Key Differences Between Employees and Contractors
Companies must identify which workers are employees and independent contractors for the IRS, primarily for tax reasons. Consider the following differences before working as—or hiring—independent contractors and employees.
Independent Contractor vs Employee Chart
1. Ownership and Proprietorship
Even as a sole proprietor, an independent contractor is technically its own business entity. Therefore, a company and an independent contractor are in a business-to-business relationship.
On the other hand, an employment relationship is formed between a business and an individual. An employment contract is formed when an employment contract is signed or once a relationship is entered into in which the individual works under the employer’s control. In other words, an employment relationship can still be formed without a physical document of employment terms and signatures.
2. The Workload
Employers do not get to dictate how much of an independent contractor’s time is taken up by other work. Freelancers often balance work from more than one client and market their services to attract others.
An employee, on the contrary, is under company control and expected to focus on work-related tasks during office hours. Completing personal projects during this time is typically frowned upon, prohibited, or even regarded as a breach of a non-compete agreement built into the employee’s contract.
3. Scope and Degree of Work Defined by a Contract
An independent contractor is only responsible for the scope of work dictated in the signed independent contractor agreement. A clearly-written contract helps manage the expectations of both parties, especially regarding due dates and other project details.
Similarly, an employment contract must accurately define the worker’s job expected to be performed by the employee, and the work is usually a key aspect of the business. However, there’s much more at stake in this relationship, possibly including benefits, other employee-related costs, and even a pension plan.
4. Payment Terms and Timeframe
Payout structures are quite different between employees and independent contractors. While employees must be paid on time at agreed-upon intervals, independent contractors submit invoices at an interval of their choosing.
For example, a freelance writer may agree to receive payment after completing an assignment for a flat fee, whereas a freelance web developer may charge clients once per month based on their hourly rate. Payments for independent contractors are more flexible than they are for employees.
5. Scheduling and Timing
Traditional employees usually have set hours when they’re responsible for reporting to work. On the other hand, independent contractors work when they please unless otherwise stated in their independent contractor agreement. Typically, the only agreed-upon time constraint is the due date of their assignment.
6. Degree of Oversight
In most cases, a client cannot control which tools or methods a contractor uses to complete the work unless it’s specifically agreed to in the contract terms. Employees are usually provided tools and may be barred from using alternatives.
7. Specialized Tax Forms
Employers file taxes for employees and independent contractors differently. For employment taxes, companies generally file a W-2 for each employee annually and other employment tax forms such as a 941 quarterly. In terms of non-employment compensation for independent contractors, companies must use a 1099-NEC starting from 2020 to report payment if the payment is at least $600 (which is why independent contractors are also referred to as “1099 employees”).
Independent contractors do not have employers that withhold taxes for them. Therefore, they must file self-employment tax (which consists of social security and Medicare tax) and income tax.
The 1040-ES allows self-employed individuals to calculate and pay estimated taxes quarterly to avoid a large tax bill at year’s end.
In addition, independent contractors who either meet certain requirements or earn a net profit of at least $400 for the year must use a 1040 (or a 1040-SR if over the age of 65) and attach a Schedule C to it for annual income tax returns. If their employer is filing a 1099-NEC, they may need to submit a W-9 as well.
Contrary to independent contractors, employees working under an employer that withholds taxes have it much more straightforward. In most cases, employees only have to file a W-4 upon hiring and when the withholding amount changes.
If all that still sounds confusing to you, here’s a simplified version of who files what for taxes.
8. Benefits and Legal Protections
Most businesses must provide their employees with certain protections and benefits, but this does not apply to independent contractors. While it’s wise to have some form of insurance (such as professional liability coverage) in a contractor agreement, contract workers are not entitled to legal protections like unemployment insurance and workers’ compensation.
9. Delegation and Other Expenses
Unlike employees, independent contractors aren’t by default barred from delegating parts of their work or consulting to other professionals. Before committing to a business relationship, the employer and the contractor should clearly lay out flexibility on such matters in their freelance contract.
The IRS “Independent Contractor vs. Employee” Test
Before 2020, hiring entities used the IRS 20-point checklist to help determine whether a worker was an employee or an independent contractor; now, the IRS has applied a less complicated approach to an independent contractor test by distilling the 20-point checklist into three categories:
- Behavioral Control
- Financial Control
- Relationship
Behavioral Control
First, the IRS examines the degree of control an employer exerts over when, where, and how an employee works.
As previously mentioned, independent contractors generally enjoy a higher level of freedom in terms of working hours, work methods, and many other aspects of work. Suppose a worker receives relatively extensive evaluations of work performance, high degrees of instruction, and significant amounts of training. In that case, the IRS generally assumes a worker to be an employee rather than an independent contractor.
Financial Control
Next, the IRS considers how much responsibility the employer holds concerning the financial aspects of the worker’s job.
For example, if an employer reimburses a worker for a particular tool the worker purchased to complete the delegated tasks, the worker is likely an employee. Although an increasing number of businesses are willing to reimburse freelancers for some expenses, most freelancers prefer to pick their own tools and obtain them with their own resources.
Relationship
Regardless of what’s in the employment contract, the IRS determines a worker’s status based on how the 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.
Hiring an Independent Contractor: Pros & Cons
Not sure whether to hire an employee or a contractor? Consider the following pros and cons:
Working as an Independent Contractor: Pros & Cons
When deciding whether you prefer working as an employee or an independent contractor, consider the following:
Consequences of Misclassification
The government wants its tax money, so it relies on each business to correctly classify every member of its workforce. Misclassified workers can wind up costing the government money—and you a fortune for the potential penalties.
The typical penalty is a fine, which can be steep depending on the severity of the offense. In most cases, the IRS will assess the situation and cut employers off 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.
Make 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. LegalTemplates offers a comprehensive portfolio of business and employment contracts with extensive legal knowledge that helps everyone, from small business owners to self-employed individuals.
