Understanding the difference between an independent contractor vs. an employee is crucial to correctly handle tax and other legal duties in business functions. Beyond legal headaches and potential issues with the IRS, it can actually have a big impact on tax liability and other obligations.
Overview of an Independent Contractor vs. an Employee
Independent contractors are professionals or workers in a trade or business that offer their expertise or service to the general public. They are typically contracted to perform work by an employer and are generally not considered an employee.
This may include professions like freelance software developers, writers, and professionals who work under a consulting agreement or independent contractor agreement.
Employees are people who work for an employer that controls what the employee does. In other words, the employer controls the how, where, and when the employee performs its work.
At-will employment is the usual form of employment, with an exception being Montana. This means employees are free to quit or can be terminated at any time as long as it’s legal.
Although these are very general definitions, there are some pertinent differences between employees and independent contractors.
Differences Between an Independent Contractor vs. an Employee
- Employment: As stated before, most employees work at will which means their employer can terminate the relationship at any time or they can quit. They work for the employer’s business and only for the employer. In contrast, independent contractors are self-employed, and they often work with multiple clients. However, some independent contractors may work exclusively for one client or have long-term contracts with a single client.
- Payment: Employees are paid a fixed salary or wage, typically on a weekly or monthly basis. Independent contractors work for a predetermined or agreed hourly or project rate. Depending on the agreement, they submit invoices for payment after the completion of a project or certain milestones.
- Control: Independent contractors work with less oversight from the employer. In other words, they usually have more flexibility to determine their own schedule and work hours and often use their own tools in their projects. Employees typically work the hours and at the location dictated by the employer. However, the level of control over work hours can vary depending on the specific agreement between the parties.
- Taxes: Independent contractors are liable for their own taxes and tax is not withheld from any of their payments. With employees, the employer is responsible for deducting taxes from their wages or salary.
- Benefits: Employees receive benefits as part of their remuneration package from their employer. In this case, the employer is also responsible for unemployment benefits. In contrast, independent contractors typically do not receive benefits from their employer. While it is rare, some independent contractors may negotiate benefits or additional compensation as part of their contract.
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IRS Guidelines for an Independent Contractor vs. an Employee
Although these differences are quite clear, there are many situations that can become gray areas between the requirements for either an employee-employer relationship or those of an independent contractor.
A good starting place could be to look at if the employment falls under one of the different types of employment contracts. For example, is it a full-time employment contract or a part-time contract? Does the contract fall squarely under an independent contractor agreement? Does it contain a noncompete agreement ? These are all important questions to ask but can also complicate things.
Although there is no one-size-fits-all approach to classifying workers, there are some guidelines the IRS uses to decide what category a worker fits in.
Using these guidelines, the IRS has set up general criteria :
- Behavioral Control: If the worker works under the control of the employer and the employer dictates the work hours, what tools the worker should use, and how the work should be done, that worker will most likely be classified as an employee. If the worker can set their own hours, use their own tools, and work with little or no control by the employer, that worker is probably an independent contractor.
- Financial Control: If the worker is paid a fixed hourly, weekly, or monthly wage and the employer deducts taxes from their payments, the worker is likely an employee. If the worker invoices the employer, their payment terms vary, and no tax is deducted from their payments, the worker is probably an independent contractor.
- Relationship: Employees are expected to do work that is essential to the business. In other words, if the work is related to the employer’s core work, the worker is probably an employee. In contrast, independent contractors do specialized work that employers may need from time to time.
- Taxes: Independent contractors are liable for their own taxes and tax is not withheld from any of their payments. With employees, the employer is responsible for deducting taxes from their wages or salary.
- Benefits: Employees receive benefits as part of their remuneration package from their employer. In this case, the employer is also responsible for unemployment benefits. In contrast, independent contractors typically do not receive benefits from their employer.
Consequences of Misclassifying an Independent Contractor vs. an Employee
When hiring an employee, the employer is responsible for withholding income, Social Security, and Medicare taxes from the employee’s salary. The employer must also pay half the Social Security and Medicare taxes due by the employee, workers’ compensation, and unemployment insurance for the employee.
Apart from these, the employer is also responsible for a variety of other requirements depending on the relevant federal and state laws, like overtime, family leave, and sick leave. With independent contractors, there are no such requirements, and the employer is only responsible for the payment of the contractor’s invoices.
So, with hiring an independent contractor being easier than hiring an employee, it’s easy to see why many businesses would want to classify a worker as an independent contractor - and this is where a misclassification can happen.
Regardless of whether a misclassification was intentional or unintentional, it could lead to serious legal and financial consequences. This can lead to reimbursement of unpaid wages, paying arrear workers’ compensation, retirement benefits, and other employee benefits.
It could also include the payment of back taxes, Medicare and Social Security contributions, and other penalties for state and federal taxes. In serious cases, it can even lead to a federal lawsuit. However, it is important to note that the specific consequences can vary depending on the jurisdiction and the specific circumstances of the misclassification.
In simple terms, employers should classify their employees correctly from the start.
Tax Implications for an Independent Contractor vs. an Employee
The above guidelines can simplify the process of classifying a worker correctly. However, sometimes it can be difficult to classify a worker. The important thing to remember is that, when there’s any doubt, the IRS generally assumes that a worker is an employee.
So, it’s always better to get certainty to avoid any of the consequences of misclassification. This can be done by filing a Form SS-8 to request a determination from the IRS. Keep in mind that the IRS doesn’t issue determinations based on hypothetical situations, but only to resolve federal tax matters.
Tax Responsibilities for an Independent Contractor vs. an Employee
As mentioned, employees are paid either an hourly, weekly, or monthly wage. They could also be paid commission and, in some circumstances, overtime. Employees are taxed on this income and will receive a W-2 form indicating their annual income. The employer is responsible for deducting federal and state taxes as well as Social Security and Medicare taxes from their income. The employer is also responsible for paying half of the Social Security and Medicare taxes.
When it comes to independent contractors, there is usually no responsibility to withhold any taxes. The independent contractor is responsible for reporting and paying their taxes. As of 2020, the only responsibility is to send each independent contractor an annual 1099-NEC form if the employer has paid the contractor more than $600 during the year. However, it is important to note that employers are required to withhold taxes from certain payments made to independent contractors if they meet certain criteria, such as if the contractor fails to provide a valid taxpayer identification number.
Final Thoughts on an Independent Contractor vs. an Employee
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