Independent Contractor vs. Employee: Everything You Need to Know
There was a time when being employed was a fairly straightforward status — either you were or you weren’t. But with the rise of consultants, professionals, freelancers, and the self-employed, it’s a bit harder to tell these days.
People who do work for others typically fall into one of two classifications: employees or independent contractors. The general difference being that an employee’s work is controlled by another party (usually the superior in their company), while an independent contractor’s work is controlled by themselves.
Now, this may seem like splitting hairs. After all, work is still being done and people are still getting paid. However, when it comes down to business — filing taxes, workers’ rights, and all other paperwork — knowing who you’re dealing with makes a big difference.
Federal and state governments, for instance, treat employees and independent contractors very distinctly.
Business owners should also be aware of their workers’ status in order to provide the correct salaries and taxes, meet the proper working conditions, and be in compliance with all labor law requirements.
In this article, we cover everything about independent contractors, their roles and responsibilities, and why they’re commonly mistaken (and misclassified) as employees.
What Is an Independent Contractor?
An independent contractor is an individual or business that offers goods or services to another individual or business. Like employees, they operate under a contract that outlines the purpose and intended result of their work.
Unlike employees, however, independent contractors are not subject to a single employer. Instead, they work on a freelance, project-by-project basis. Rather than an employer, they are hired by a client or customer (often multiple clients or customers), and in place of salaries, they receive business income.
But no matter the hours, the pay, or even the type of work done, the distinguishing factor of an independent contractor is that they control how and when they operate.
Independent contractors are essentially their own business — managing their own hours, filing their own taxes, and running their own personal operations.
Ways to Check If Someone Is an Independent Contractor
You may think the choice of work status is completely between the worker and the company. As long as both parties are in agreement and get everything in writing, it’s a done deal, right?
Wrong. Many federal and state governments have a lot to say about how a worker is classified — the Internal Revenue Service (IRS), the United States Department of Labor (DOL), the National Labor Relations Board, the Unemployment Compensation Board, Workers’ Compensation Insurance Agency, the state’s tax department, and the state’s department of labor.
Thankfully, there are many tests to figure out a worker’s classification. The most common are the “Right to Control” tests. These help by determining who has the right to control the means and manner of the work being done. If the company has more control, the worker is generally an employee. If the worker has more control, they are likely an independent contractor.
IRS Tests for Independent Contractor Status
The IRS is probably the most decisive agency when it comes to a worker’s status. Although every case is different, the department provides a lot of information to help determine whether someone is an employee or independent contractor.
In the past, the IRS used a 20 Factor Test to evaluate a worker’s status. Some of these factors were the hours and place of work, method of payment, exclusivity of work, and the right to discharge or quit. These have since been compressed into three general aspects, referred to as the Common Law Test:
- Behavioral Control: Does the business have a right to direct and control how the worker does their task? This includes when and where they work, what tools or equipment to use, and any training they may require to perform their tasks.
- Financial Control: Does the business have a right to control the business aspects of the worker’s job? This deals with any money matters concerning the worker, including how they get paid (i.e., per month, per hour, per job), what expenses they can reimburse, what items can they invest in, and if they are free to seek out other business opportunities.
- Type of Relationship: How do the parties work together? Are there written contracts describing the business relationship, how long it will last, and any employee-type benefits (i.e., insurance, pension plan, sick pay) the worker will receive?
In their latest Employer’s Supplemental Tax Guide, the IRS even offers a few fictional, yet detailed, industry examples:
In the building and construction industry, for example, they refer to “Milton Manning, an experienced tile setter, [who] orally agreed with a corporation to perform full-time services at construction sites. He uses his own tools and performs services in the order designated by the corporation and according to its specifications.
The corporation supplies all materials, makes frequent inspections of his work, pays him on a piecework basis, and carries workers’ compensation insurance on him. He doesn’t have a place of business or hold himself out to perform similar services for others. Either party can end the services at any time. Milton Manning is an employee of the corporation.”
A second example uses the computer industry, in which “Steve Smith, a computer programmer, is laid off when Megabyte, Inc., downsizes. Megabyte agrees to pay Steve a flat amount to complete a one-time project to create a certain product. It isn’t clear how long it will take to complete the project, and Steve isn’t guaranteed any minimum payment for the hours spent on the program.
Megabyte provides Steve with no instructions beyond the specifications for the product itself. Steve and Megabyte have a written contract, which provides that Steve is considered to be an independent contractor, is required to pay federal and state taxes, and receives no benefits from Megabyte. Megabyte will file Form 1099-MISC, Miscellaneous Income, to report the amount paid to Steve. Steve works at home and isn’t expected or allowed to attend meetings of the software development group. Steve is an independent contractor.”
DOL Tests for Independent Contractor Status
The DOL also has their own comprehensive test for worker classification. As the department enforces The Fair Labor Standards Act (FLSA) — which establishes minimum wage, overtime pay, child labor, and recordkeeping laws for full-time and part-time workers — they have provided a way to determine a worker’s status, using an Economic Realities Test.
The test is made up of six factors:
- Is the work an integral part of the employer’s business?
If the worker is tangential to the business, such as maintenance or annual services, they are more likely a contractor. If the worker supervises other employees, deals with customers, or performs primary work that the business depends on, they are most likely an employee.
- Is the relationship between the worker and the employer indefinite or ongoing?
Fixed, project-based relationships are more typical of independent contractors, while indefinite, ongoing relationships usually indicate employment status.
- How does the worker’s investment compare to the employer’s investment?
If workers purchase their own tools and equipment, they are usually in business for themselves and likely to be independent contractors. Workers who are reimbursed for work-related expenses, however, are usually employed.
- What is the employer’s nature and degree of control?
Who decides things like pay rate, delivery schedule, or how the work is performed? Can the worker work for other businesses? If the worker decides these things, they are most likely an independent contractor. If the worker has to comply with business rules and regulations, they’re usually an employee.
- What affects the worker’s opportunity for profit or loss?
Can the worker earn more if they perform more efficiently or expand their skill set? If the worker can profit or lose money from their business decisions, they are an independent contractor. Employees, on the other hand, make money either way.
- Does the work require special skill and initiative?
This may be a bit difficult to gauge, as both employees and independent contractors can be highly skilled at their work. If the skills show that the worker uses their own independent judgment or initiative (entrepreneurial, managerial), then they might be an independent contractor.
If a worker tests as economically dependent upon the company, they are likely an employee. If a worker tests as economically independent of the company or is otherwise self-reliant, they are likely an independent contractor.
State Tests for Independent Contractor Status
There are worker classification tests on the state level, as well. An increasingly common one used in nearly every state is the ABC test. Much simpler in format, the test requires that all three factors must be met to consider a worker as an independent contractor. These are:
- That the worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact;
- That the worker performs work that is outside the usual course of the hiring entity’s business; and
- That the worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed.
If a worker can’t answer yes to all three parts of the ABC Test, they are usually classified as an employee.
Remember, these are multi-factor balancing tests — no one or set number of factors can definitively say a worker’s status is an employee or an independent contractor. There are many other ways to aide in the determination process, but what really matters is the total picture.
The Importance of Classifying a Worker Correctly
The big commotion over worker classification is primarily due to tax payments — a lot of tax payments.
For every worker classified as an employee, the hiring company is required to withhold, deposit, report, and pay employment tax, social security tax, Medicare tax, and Federal Unemployment tax. It must also file paperwork specific to hiring employees.
If a worker is classified as an independent contractor, on the other hand, the hiring company has significantly much less to do. It is now the independent contractor who must withhold, deposit, report, and pay their own income taxes using Form 1099.
The IRS regards all independent contractors as self-employed, obligating them to pay a self-employment tax of 15.3% — comprised of the full 12.4% for social security and 2.9% for Medicare.
Independent contractors are also not eligible for certain monetary incentives typically given to employees. This includes worker’s compensation, insurance that provides cash or medical benefits to workers who are ill or injured as a direct result of their employment; and unemployment insurance, which is temporary financial assistance for workers who are unemployed through no fault of their own.
On the bright side, independent contractors are able to lower the amount they pay in taxes by claiming a number of available deductions (such as business expenses for a dedicated home office, medical and dental fees, work-related education, and their children’s day care). These deductions work in an independent contractor’s favor. The more they can deduct, the less they’ll have to pay in taxes.
The Case of Misclassifying a Worker
About 10-20% of business owners tend to misclassify their workers. The issue has started making a lot of news headlines in recent years, mainly concerning companies like Uber, TaskRabbit, Grubhub, and others offering gig-based services.
In the case of Uber, for instance, there is an entire website published by the drivers’ legal representatives detailing every step of the class action lawsuit. In a nutshell, Uber drivers wanted to be recognized as employees, rather than independent contractors, in order to get health care and other benefits. This has since been settled with Uber drivers receiving $20 million from the company, but still keeping their independent contractor status.
Other confusing cases, noted by the DOL, may be construction contractors, organization volunteers, franchise arrangements, and many others.
While misclassifications can be an honest mistake, some employers do so intentionally as a way to reduce their labor costs, taxes, and liabilities.
By classifying a worker as an independent contractor, the company avoids paying social security, Medicare, and unemployment insurance taxes for the worker — a big chunk that they would otherwise have to shoulder.
They also don’t have to worry about the worker receiving overtime pay, organizing as a union, claiming their workplace civil rights, or enrolling in the employer-based health and pension plans.
Not only is this unfair, but it’s also a dangerous and tricky business. If caught, an employer can face a slew of back taxes, penalties, fines, and even jail time.
Back to Business
If you take the time to dig into the details, there’s a big difference in how workers are classified. Employees typically have less freedom in how they work, but enjoy many other work benefits and conveniences. Independent contractors, on the other hand, have greater freedom in their work, which comes along with greater responsibilities.
Whether you classify as an employee or independent contractor, it’s always important to be clear about the working relationship you’re getting into.