Independent Contractor vs. Employee

Understanding the difference between an independent contractor vs. employee is vital to paying the proper tax rates, and avoiding severe penalties and consequences. Here's everything you need to know about the two.

To many employers who may have never really thought about the issue, there seems little difference between an independent contractor and an employee. The two classifications may well work side by side doing similar or even identical work, after all. However, legally there are important differences.

When the job title doesn't match the legal definition, regardless of the reasons for the title, problems can result. Employment status has an effect on a range of issues from benefits to tax liability and other financial considerations. Those considering accepting an independent contractor job should keep in mind some key differences between the two.

What Constitutes an Employee

Employees work for a single employer, at set hours established by the employer. They often (but not always) receive benefits which can include healthcare and paid time off. They work at the discretion of the employer, and under their direct control. The employer controls what tasks are completed, when, and how. Employees, in return, don't generally make investments or incur costs related to the job and receive a specific net salary after tax and other contributory withholdings.

If an employee is terminated, they may be eligible to get unemployment. If they're hurt on the job, they can receive workers' comp benefits, and the circumstances for termination vary based on whether or not they are in an "at will" state. They're covered by both state and federal wage and hour laws, as well as anti-discrimination and workplace safety rules. Finally, they're entitled to unionize.

What Defines an Independent Contractor

Independent contractors, on the other hand, provide consulting services to as many companies as they like. They set their own hours and pursue their work according to their own methods and approach. They may work out of a private office or their own home. They receive no benefits from their employer, but in turn, receive only minimal oversight and control. They incur many of the costs associated with the job and tend to have very specialized skills.

Independent contractors do not have taxes and contributory withholdings taken out of their paychecks. Rather, they pay self-employment tax at a higher tax rate. They are ineligible for unemployment or worker's compensation and can be let go for any reason at any time, limited only by any contract they've signed. They are paid according to this contract, as well, and aren't entitled to overtime. In general, labor laws including discrimination and safety rules, don't apply, and they're not permitted to form a union.

Determining Which is Which

The IRS, as well as most states, have rules for how to define independent contractors. These rules focus largely on how much control an employer exercises over the services provided. Workers who supply their own tools and equipment, for example, are independent contractors. Workers who can be dismissed at any time, and can choose when to work and when not to, are independent contractors. If the work is essential to the business, on the other hand, it's more likely the worker is an employee.

Many agencies use what is called an "economic realities test" to properly interpret independent contractors and employees as they apply to the Fair Labor Standards Act (FLSA). This test considers how reliant the worker is on the business for which they work. If, for example, they gain the lion's share of salary from the business, they may be considered an employee.

Besides the FLSA, courts tend to consider the degree of control the employer has over the work, the level of loss that each party stands to suffer if the relationship dissolves, who pays for materials, the skills required, the permanence of the position, and similar factors. Of these the "right to control" factor is often the most important.

Some employers deliberately misclassify workers to save money — in fact, the DOL estimates that as many as 30 percent of employers engage in this illegal practice. It's a serious problem that costs the government (both Federal and state) billions of dollars in tax revenue.

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