Independent Contractor vs. Employee

Independent Contractor vs. Employee: What's the Difference

Knowing the differences between an employee and an independent contractor will help you avoid misclassification issues. Find out if your workers are properly classified.

Anja Simic
Written by Anja Simic
September 17, 2021
Contents
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Welcoming new people to your company is exciting! Most employers (rightfully!) focus on creating an excellent experience for new hires and starting them on the right foot. But you must also be aware of legal and tax issues surrounding these new business relationships before signing a contract. One of these considerations is whether your worker is an independent contractor or a full-time employee.

Independent contractors and employees differ in terms of payment, company responsibilities, scope of work, and so much more. Some differences are stark while others are subtly–but all differences are essential to avoid misunderstandings and misclassification. This article provides an in-depth explanation of all the differences so you can hire with confidence.

EMPLOYEE

 

CONTRACTOR

Works for an employer

Business relationship

Works with one or more companies as clients

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 doesn’t need  much/any 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

Mandatory benefits

Doesn’t receive any employment benefits or FLSA protection

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 gets 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 hire 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 they should 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 to have a longterm business relationship. And in most cases, within the employment contract, you outline a set amount of hours they should work. 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 that 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 business and independent contractor license. Common law considers independent contractors self-employed, which means they work for themselves. Federal employment laws don’t cover independent contractors.

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The differences between employees and independent contractors

As we mentioned, the business relationship employees and independent contractors have with their employer (or clients in the case of contractors) differ 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 fit, 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 “hiring” process is usually faster since there are not several rounds of interviews. 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 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, etc. It’s the contractor’s responsibility to invoice the client to get paid.

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 9-5), 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 for using any of it. Remote employees often receive a work-from-home stipend to set up a home office. The employer also covers their business expenses, such as business travels, or reimburses them.

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 Fair Labor Standards Act (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 PTO, maternity leave, or wellness programs. But they might receive a bonus from their client if the client mentions that possibility in the independent contractor agreement.

Taxes and tax forms

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

As a taxpayer, an independent contractor usually fills out Form W9. They’ll write out their name, address, tax identification number (TIN), and certification about backup income tax withholding from the IRS. In case you’re hiring a foreign contractor, they will need to fill in the 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, in case they’re reporting miscellaneous income.

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.

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. The client only controls the outcome of their 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.

3 ways to check a worker's classification

The Internal Revenue Service 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 coincide in all aspects 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’ best is 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. The idea behind this is that 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, is likely an employee.

Department of Labor's ABC test

The ABC test is a set of guidelines that 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.

In 2019, this test looked similar to the three criteria used by the IRS. It said 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

These rules seem more strict and the DOL introduced them 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 in obligation 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.

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 an SS-8 too.

Employee vs independent contractor FAQs

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 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 actual 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, so make sure you’re implementing this change when you add them to payroll.

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

Employees provide companies 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.

Independent contractors provide specialized labor at a cheaper rate (because you don’t need to cover employment taxes or 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. If the IRS discovers you’ve misclassified workers knowingly, the fines and penalties are way harsher.

Hire employees and independent contractors with Deel

Deel helps you easily hire 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. Deel also lets you convert independent contractors to full-time employees with just a few clicks. 

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?

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