Independent Contractor vs. Employee

What’s the Difference Between a Contractor and Employee?

Hiring workers? Understanding the difference between a contractor and employee can save your company from misclassification penalties. Here’s what to know.

Anja Simic
Written by Anja Simic
September 17, 2021
Contents
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Key takeaways

  1. An employee is a worker that gets hired and managed by an employer and receives mandatory employee benefits.
  2. An independent contractor is a worker who provides services to a company on a short-term or per-project basis and doesn’t receive employee benefits. 
  3. An employer may face misclassification penalties if the authorities discover they’ve misclassified an employee as a contractor.

During the hiring and onboarding process, employers typically focus on creating an excellent experience for their new team members. But they must also be aware of the legal and tax details involved in a new business relationship—especially the difference between a contractor and employee.

Independent contractors and employees differ in terms of payment, company responsibilities, scope of work, and so much more. Understanding the differences is essential to avoid misunderstandings and misclassification. This article provides an in-depth explanation of the differences so you can hire with confidence.

Disclaimer: This content is focused on US employment laws and processes. It does not constitute legal advice. Please consult a legal professional and comply with local employment laws.


EMPLOYEE

 


INDEPENDENT CONTRACTOR

Works for an employer

Business relationship

Works with one or more client companies

Works according to company-regulated schedule

Schedule

Sets their hours

Receives tools or reimbursements from employer

Tools necessary for work

Has their own tools and covers any business expenses

Receives employer-provided onboarding and training

Training

Comes with skills and expertise and needs little to no training

Shares taxes with the employer and has taxes withheld from gross pay

Taxes

Pays self-employment taxes

Files W-2, W-4

Tax forms

Files W-9, W-8, 1099s

Receives benefits like health insurance and retirement contributions

Mandatory benefits

Doesn’t receive any employment benefits or Fair Labor Standards Act (FLSA) protections 

Receives regular, fixed payments 

Compensation

Receives hourly or project-based wages

Gets direct supervision from a manager

Employer supervision

Receives minimal supervision and controls their own process

What is an employee?

An employee is a worker that is hired and managed by an employer and receives mandatory employee benefits.

When you hire an employee, they work for you, not for themselves. You formally employ them to carry out a specific job function, for a specific wage or salary, and usually on a set schedule. During that time, they work under your direct supervision and control—you’re in charge of providing them with work-related tasks to complete.

Regardless of whether your employee is full-time or part-time, or remote or office-based, you generally provide them with an offer letter or employment contract to specify the terms of their employment.

Most companies hire employees with the intent of having a long-term business relationship. And in most cases, within the employment contract, you outline a set amount of hours they should work per day or week. Depending on your company, you’ll either pay employees by the hour or by salary. 

What is an independent contractor?

An independent contractor is a worker who provides services to a company on a short-term or per-project basis and doesn’t receive employee benefits. 

Independent contractors work under individual written contracts, which means your company doesn’t officially hire them. They work with you rather than for you, and don’t have a fixed salary or typical perks and benefits associated with full-time employment. 

You pay an independent contract worker once they complete a job. And once they complete a job, that’s the end of your short-term relationship with them (unless you hire them for additional services). Many independent contractors have long-term clients for whom they complete multiple projects.

Many contractors have their own businesses and independent contractor licenses. Common law considers independent contractors self-employed, which means they work for themselves. Federal employment laws don’t cover independent contractors.

The differences between employees and independent contractors

As we mentioned, the business relationship employees and independent contractors have with their employer (or clients) differs in several aspects. 

Hiring and onboarding 

A potential employee applies to a job within your company and typically goes through several rounds of interviews, often starting with a recruiter, talent acquisition specialist, or someone from your HR department. If the hiring manager or department likes the candidate’s credentials and experience and considers them a good culture add, you offer them the position.

After the employee accepts the job offer, the company typically provides a week or two of onboarding: meeting the team, learning about their responsibilities, software training, etc.

An independent contractor submits an application (which usually includes a portfolio) to a specific department within your company, skipping the initial HR screen. The contractor hiring process is usually faster since there are not several rounds of interviews, and they are recruited directly. The contractor might complete a proposal outlining the services they can provide. You sign an agreement and start working without an onboarding process.

Compensation

Employees are on your direct payroll. When you sign a contract with them, you agree on the employee’s gross salary, paid monthly, weekly, or bi-weekly. The salary is usually fixed, but the employee may receive bonuses or commissions, depending on their performance. 

They may also have a fixed hourly wage if their working hours are not the same every week. Check out our guides on global payroll management and small business payroll management to learn more about paying domestic and foreign employees.

Independent contractors don’t have a salary. They get paid by the hour or after each project, so their income isn’t the same every month. Their clients don’t withhold any tax deductions from their payments as the contractor is responsible for taking care of their own taxes, health insurance, and retirement contributions. 

It’s the contractor’s responsibility to invoice the client to get paid. Some clients may require their contractors to follow an invoicing and time-tracking policy. Hiring and paying foreign independent contractors can become complicated, as you have to navigate multiple currencies, exchange rates, and bank regulations.

Work schedule and location

The employer typically determines the work schedule for their employees based on the company policy. In-office employees have fixed working hours (often nine to five), while remote employees have more flexibility in their work schedules.

Independent contractors usually organize their own working hours. The client doesn’t control when they complete the work, as long as they don’t miss the deadline. Independent contractors almost always work from home (or wherever they prefer).

Tools and equipment 

Employees use the equipment and tools provided by the company they work for. Whether it’s the office space, furniture, computers, or software, they’re not required to pay to use any of it. Remote work often involves workers receiving a work-from-home stipend to set up a home office. The employer also covers or reimburses their business expenses, such as travel.

Independent contractors work with multiple clients in most cases, so they have their own “toolbox” and are responsible for getting their own equipment to do the work. They usually don’t get reimbursement for any business expenses, but employers may elect to provide specialized software or equipment necessary to complete the job.

Training

When a new employee joins a company, the employer typically provides them with training to ramp up. Employees go through the onboarding process to meet coworkers, learn about the team’s workflows and tools, and gain job-related skills. Employees also often depend on employer-provided learning and development programs for ongoing training and career progression. Training employees is a significant investment. 

The situation is different with independent contractors. Independent contractors don’t require onboarding since the client hires them for their expertise. And since these business relationships are usually short-term and the company is only a temporary client, the independent contractor receives no ongoing training. 

Employment laws and employee benefits

Federal and state employment labor laws, like the FLSA, cover employees but not independent contractors. Employees are on the employer’s payroll and receive health insurance, Social Security, workers’ compensation, unemployment tax, and other protections. They also have the right to minimum wage

Independent contractors provide themselves with healthcare and other benefits employees receive from their employer. Independent contractors do not receive employee benefits like paid time off (PTO), maternity leave, or wellness programs. But they might receive a bonus from their client if it’s included in the independent contractor agreement.

Taxes and tax forms

For tax purposes, an employee will typically fill out Form W-4 when they take on a new job. They provide their name, address, Social Security number (SSN), tax filing status, and exemptions. The employer also needs to file Form W-2 for their employees to report their annual income. The employer covers payroll taxes and FICA taxes (Social Security and Medicare taxes).

As a taxpayer, an independent contractor usually fills out Form W-9. They’ll write out their name, address, Tax Identification Number (TIN), and certification about backup income tax withholding from the Internal Revenue Service (IRS). If you’re hiring a foreign contractor, they will need to fill in Form W-8BEN (for individuals) or W-8BEN-E (for business entities).

Independent contractors are often small business owners, so they pay self-employment taxes. When filing their own taxes, contractors typically use IRS Forms 1099-NEC, or sometimes Form 1099-MISC if they’re reporting miscellaneous income.

Learn more about independent contractor taxes and employee taxes in our article about the differences between 1099 vs. W2 forms.

Employer supervision and control

When you hire an employee, you determine their scope of work, schedule, and working hours. You coach them to complete tasks and develop skills and take on the financial risk of a failed project. In exchange, employers generally own anything created by the employee during the time of employment. Some employers implement attendance and time-tracking policies for their workforce to monitor their productivity.

On the other hand, independent contractors manage themselves and carry the risk if they fail to deliver what the client asked for. Independent contractors decide where, when, and how they complete their projects without the client’s supervision. 

Managing independent contractors typically only includes the client controlling the outcome of the contractor’s work, although in some countries, an independent contractor’s work is their intellectual property. Learn more about protecting intellectual property when you run a global team.

Termination

Firing an independent contractor is generally easier than terminating an employee, so long as you have a written contract that outlines the termination provisions. To terminate an employee, you must follow the termination laws of the employee’s country, otherwise, you risk facing penalties and accusations of wrongful termination.

Three ways to check a worker’s classification

The IRS has a set of rules that determine the economic realities of the business relationship and the employee’s status. But the IRS’s definition of an employee doesn’t completely coincide with definitions from other authorities like the US Department of Labor (DOL). It’s difficult to point to one factor that determines employment status, so it’s best to comply with all three of the following checks.

IRS guidelines to determine worker status

The IRS uses three broad criteria to assess the employment relationship: behavioral control, financial control, and type of relationship.

Under the Fair Labor Standards Act, these questions determine the nature of the relationship and the subsequent classification and tax liability that goes with it.

Behavioral control

If the employer has the right to instruct how work gets done, this is a sign of an employee. Examples of behavioral control include hours and schedules, location, methods, and tools. For instance, providing training is strong evidence of an employer-employee relationship.

Financial control 

Financial control looks at how much an employer controls the worker’s financial and business aspects of the job. Employees receive a set salary or wage and employee benefits. They almost exclusively work for one employer, especially if they work full-time.

Type of relationship

If a person you hired provides you with a service that is essential or integral to your business, they are likely an employee, as workers responsible for the core business should enjoy statutory benefits (such as health insurance and sick days).

Another factor is the permanency of the relationship. Independent contractors usually work on a short-term basis for pre-determined projects and periods. Any long-term relationship, especially if the scope of work is essential to the business, likely involves an employee.

Department of Labor’s ABC test

The ABC test is a set of guidelines the DOL uses to classify workers as contractors or employees. Authorities may not apply this test in the same way in every state, so in some, it’s also applicable to wages and working hours.

As of this writing, this test is similar to the three criteria used by the IRS. It says that a worker has independent contractor status if:

  • The hiring entity doesn’t control or direct the worker
  • The worker performs work outside of the hiring entity’s core business activities
  • The worker customarily performs the type of work in question as an independent business

The DOL introduced these rules when the gig economy started booming. There were updates to the ABC test in 2020 regarding types of professions that the law may consider as independent contractors if they meet the mentioned criteria. However, not all states accept this test as the state law—like California, for example—so you’re not obligated to perform it.

IRS’s (retired) 20-factor test

Another way to determine employee status is the common law 20-factor test. This test is no longer officially in use, but it provides concrete questions to help you determine the status of your worker.

Use Form SS-8 to get an official ruling from the IRS

Suppose you and your accountant are still unsure of a worker’s classification. In that case, you can ask the IRS to step in and determine their working relationship by completing Form SS-8 (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding). It may take at least six months to review your case. A worker who believes they are incorrectly classified can submit Form SS-8 too.

Frequently asked questions about hiring an employee vs independent contractor 

Can you change the worker’s status at some point?

Yes. You can change your worker’s status from contractor to employee at any point if you’re happy with their work or if they become crucial to your business. The first step in this process is to determine if they meet all the criteria necessary to be an employee by using one of the tests we mentioned in the previous section.

If you determine that you can convert the contractor into an employee, you’ll be switching from Form 1099 to Form W-2.

The next step is to notify the worker, give them your official offer, and prepare an employment contract to sign after you negotiate the terms.

After this, your new employee will go through the usual onboarding process and training. Your job is to help them adjust to their new role and learn how everything works for full-time employees.

Your HR department will need to collect all the necessary information and store it in the new employee record. You’ll no longer be paying your new employee through a W9 Form, so make sure you’re implementing this change when you add them to the payroll. Use our contractor to employee conversion policy template to get started.

What are some benefits of working with employees and independent contractors?

Employees provide companies with long-term labor with a high degree of control. You get a dedicated worker you can shape and re-assign as you both see fit.

One of the biggest benefits of hiring independent contractors is access to specialized expertise at a lower cost. Employees typically cost more to hire and retain than independent contractors because you need to cover employment taxes and employee benefits. 

Are there any penalties if you misclassify your workers?

Yes. Misclassifying your employees as contractors is a serious issue in most countries. An employer may face several types of misclassification penalties if the authorities discover they’ve misclassified employees as contractors.

In 2016, Uber paid a $100 million settlement for federal tax evasion because of employee misclassification. Other than financial penalties, there are legal consequences, harmed reputation, and even jail time. Use this assessment to determine if you're at risk of misclassification.

What is a 1099 employee?

Independent contractors are sometimes referred to as 1099 employees, though they are not technically employees. They’re called 1099 employees because of the 1099 tax form they complete.

What is a contract job?

A contract job is a fixed work assignment that an independent contractor completes. The independent contractor is hired to complete a specific job for a predetermined amount of time and money. Some contract jobs are short-term (one month), while others are longer (one year or more). Determining whether you should become a full-time vs. contract employee depends on your goals, preferred benefits, and ideal work environment.

Confidently engage employees and independent contractors with Deel

Deel helps you easily engage and pay both independent contractors and employees anywhere in the world. 

We believe making global payments shouldn’t be a challenge, so we enable you to fund payroll with just a click and automatically calculate taxes without lifting a finger. Our multiple currency options and various withdrawal methods make it even easier for your team to get paid on time, every time, so that you can have one happy team. 

Sound like something your business could use? Book a demo to see Deel in action.

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