Independent Contractor vs. Employee

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Independent Contractor vs. Employee: What’s the Difference?

The difference between an Independent Contractor vs. Employee is an important issue for employers to understand. Beyond legal headaches and potential issues with the IRS, it can actually have a big impact on tax liability and other obligations.

Classifying Workers

Workers can be classified in many ways, including employees or independent contractors. This distinction may sound simple at first, but it can be complicated when the relationship between the employer and the worker is a borderline case.

In other words, an independent contractor agreement may have all the necessary requirements to be classify the relationship as such, but some features may point to the relationship being an employer-employee relationship.

And the distinction isn’t only in name. The classification of the relationship forms the foundation of the reciprocal rights and obligations of the employee and the worker. Besides, the distinction between the two is also important when it comes to the employer’s tax liability.

Employees and Independent Contractors – How They Are Defined?

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 not considered an employee.

This may include professions like freelance software developers, writers, and also professionals that 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 difference between employees and independent contractors.

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What Is the Difference Between an Employee and an Independent Contractor?

  • 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 typically work with multiple clients.
  • 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 without oversight from the employer. In other words, they 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.
  • 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 wage 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.

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IRS Test for Worker Status

Although these differences are quite clear, there are many situations that can become grey areas between the requirements for either an employee-employer relationship and 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 three 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 works 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 wage 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 a Worker

When hiring an employee, the employer is responsible to withhold 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.

In simple terms, employers should classify their employees correctly from the start.

Getting Worker Status Determination

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.

How Employees and Independent Contractors Pay Taxes

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 indication their annual income. The employer is responsible to deduct federal and state taxes as well as Social Security and Medicare taxes from their income. The employer is also responsible to pay half of the Social Security and Medicare taxes.

When it comes to independent contractors, there is no responsibility to withhold any taxes. The independent contractor is responsible for reporting and paying their taxes. As from 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.

If you have any questions about employee classification or the different between an employee and independent contractor, it is best to consult a highly trained employment lawyer for guidance.

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