What is an Employee vs. an Independent Contractor?

How much control do you want over the people who work for you? This serious question is often at the heart of the decision by business owners as to whether they hire employees, independent contractors, or a mix of the two. 

The term “gig economy” is tossed around a lot these days, and it refers to the common use of independent contractors because of the fewer strings attached.

Choosing one or the other comes with a host of baggage that you need to carefully consider as a business owner. This baggage includes everything from whether the people you hire have Form W-2s or Form 1099s to whether you’ll provide benefits or even be able to control their behavior while working for you. 

What’s the Difference?

Before we discuss the pros and cons for employers, let’s go over the definitions:

Employee 

Employees are paid a set wage or salary in set intervals, weekly, monthly, or other agreed-upon times. Employers can set rules governing behavior, dress code, and when and how work is accomplished. 

Typically employees receive benefits of some kind, such as health insurance or 401(k) retirement savings.

Independent Contractor 

Contractors are self-employed people who are tasked with a set goal or task for a particular project. They may be contracted for long periods to accomplish recurring jobs if needed. 

These workers receive no benefits and usually don’t have set hours, nor are they required to adhere to any behavior or dress code rules. Employers also have no control over how contractors complete their objectives.

So why would a company want to hire independent contractors over employees?

Tax Considerations

When you hire direct employees, your taxing situation gets more complicated. The IRS will require you to withhold, deposit, report, and pay the appropriate employment taxes, in addition to filing special paperwork. 

Independent contractors don’t cause nearly the tax complication. Because they technically work for themselves, the tax burden come April 15th is theirs. There are no benefits for employers to track, no unemployment insurance to calculate, nothing. 

During tax time is when the difference between a Form W-2 and a Form 1099 comes into play. Employees get form W-2s, which show all pertinent info, from withheld Social Security to income tax. A form 1099 just proves to the IRS that a particular contractor did work for you.

When hiring an employee vs. an independent contractor, there are two more forms you’ll need to be aware of, Form W-4 and Form W-9. These are the forms your hire needs to fill out, with employees filling out a Form W-4 and independent contractors filling out a Form W-9. 

The Form W-4 is what an employee fills out so you can properly withhold federal income taxes, while a W-9 helps the independent contractor report their income.

How the IRS Views Employees vs. Independent Contractors

The IRS likes specificity, so we’ll be specific here, too. You can employ three tests to identify whether someone working for you is an employee or an independent contractor. 

Behavioral Control

How much do you directly control those who work for you? Their time, the tools they use, the clothes they wear, how they appear on social media, and other factors would be under your purview as an employer.

Independent contractors don’t have to report to you in any way except to provide you with the work you asked them to deliver. The question is, how much control do you want? Independent contractors would not be the way to go if you have strict protocols for how the people you pay represent you.

Financial Control

Employees earn regular wages, but independent contractors are paid by the job. According to the IRS, Independent contractors have a significant investment in their business, which means they purchased their equipment, paid for their training, and have otherwise poured their own money into what they need to accomplish jobs. 

If you want to retain ownership over the tools required to make your company operate, you want employees. You want independent contractors if you don’t care about how the job gets done and don’t want regular payroll stress and overhead.

Type of Relationship

Permanency is important. If you pay someone to install a new phone system in your office, they’re an independent contractor. If you pay someone to answer those phones every day, they’re an employee. 

Is your relationship with the person one and done? They’re an independent contractor. Is your relationship with the person ongoing, and do they report to you constantly? They’re an employee.

There is some wiggle room on these definitions, and there isn’t one single deciding point that says, “this person is a _____!” But, you can check the Common Law Test, which, while the IRS no longer uses it as a legal standard, still exemplifies their way of thinking.

What Happens When You Misclassify a Worker?

Nothing good. Frequently, class action lawsuits. In the last few years, Uber and a slew of other businesses have faced angry workers who have felt like they’ve been taken advantage of by receiving the worst of both worlds. 

Usually, this means the workers have been taken on as independent contractors but treated as employees in everything but name. The companies they worked for could avoid paying benefits or fair wages while expecting employer-level control.

Then there are the problems you’ll face with the federal government if you misclassify employees. The US Department of Labor says, “employers must not misclassify an employee for any reason, even if the employee agrees.” 

Once the IRS finds out that you misclassified employees, they’ll require all back taxes and penalties, and then they may even require you to provide benefits for the independent contractor who has now become an employee.

What if Misclassification Was an Accident?

Ultimately, this doesn’t matter. The employer could have had the best intentions, but in the eyes of the IRS, the law is the law. This stubbornness is why understanding the definitions is essential for businesses. 

When in doubt, a competent, experienced CPA can make sure all workers are properly classified. You can even fill out a Form SS-8, requesting that the IRS determine whether a worker is an employee or an independent contractor.

Now, if you misclassify an independent contractor as an employee, the penalties are far less stiff. It’s pretty unusual for an employer to do this because of the hassle it represents in terms of taxes, paperwork, and onboarding. If you’re in doubt, the IRS won’t usually frown on you going ahead and making someone an employee.

What Kinds of Independent Contractors Are There?

There are plenty of examples of people you’ve probably worked with often but never thought of as independent contractors. People like:

Freelancers

Freelancer is a broad term, but if you’ve hired a graphic designer, voice actor, writer, videographer, or artist of any type to fulfill a task for a project, they are an independent contractor. 

Regardless of how you found them, whether on a site like Fiverr, through their website, or from a recommendation by a friend, if they’re not continuing to work for you, they’re an independent contractor.

Lawyers

Even if you have lawyers on retainer with whom you have a good relationship that stretches back years, unless you dictate their hours and have them report to your office, they’re probably not direct employees. You might hire a firm to handle certain cases or legal issues, but that doesn’t mean they have to fill out a Form W-4.

Doctors

You didn’t pay for their stethoscopes or their tongue depressors, although the bills you receive from them may make you feel like you should have more say in what they do. 

They have a “job” in regards to helping you stay healthy, but you pay their bill when you’re done, and if you never darken their practice’s door again, they’re no longer beholden to you in any way.

Real Estate Agents

You might not think of them as independent contractors, but that’s what they are. You pay them to help find a house or business property, they get a cut when you make a purchase, and that’s it. You might have a favorite realtor, but they’re not your employee.

There are more examples, including dentists, mechanics, IT professionals, and more. Anyone you pay for a specific project is finished working for you when they’ve completed their work.

How Can I Ensure I Don’t Misclassify?

If you’re concerned you might misclassify an independent contractor as an employee, consider some of these effective solutions:

Upfront Contracts

Make sure the contract you draw up conforms to the definitions of what the IRS considers an independent contractor. Then ensure you and the person you’re hiring agree on the terms before the work begins, as expressed in the contract. 

Your relationship is outlined in black and white, and there’s no confusion.

Don’t Monitor Behavior

Independent contractors don’t answer you regarding how they dress, what they do on their lunch breaks, how long their lunch breaks are, if they take lunch breaks, etc. 

Don’t make them work onsite. Don’t dictate which tools they can use. In other words, their process is their process, and the finished product is your only concern.

Keep Timelines Short 

If you draw up a 30-year contract, you just hired an employee. The way the IRS sees it, you’re hiring them for a specific task, and if you want to hire them again later, that’s fine. 

Don’t try to skirt the law by making a contract for an independent contractor that reads, “will wash my car every day until I retire.”

Which Should I Hire?

We’ve come full circle! How much control do you want? How many tax records are you willing to process? Do you need people for a specific project or ongoing corporate goals? 

Once you can answer these questions, you’ll know the answer. Just remember, whichever you choose, the IRS is watching you.