Independent Contractor vs. Employee: What Business Owners Need to Know

Independent Contractor vs Employee

For small business owners, deciding whether a worker is an independent contractor vs. employee is tricky. Companies of all sizes rely on both employees and independent contractors to run their businesses at full productivity, but there are some important differences between contractors and employees.

If you’re considering hiring an independent contractor (IC), you need to understand these differences, what the law says about classifying someone as an independent contractor, and the implications of how you contract with and compensate the individuals who work for you.

What Is an Independent Contractor?

For all but the smallest companies, you can’t operate your business all by yourself. You need another person to perform some of the work, whether you simply need more manpower to cover hours or you require specialized skills outside of your area of expertise.

You can hire this person as an employee or as an independent contractor (IC), sometimes referred to as a freelancer or consultant.

Employees are hired to become part of your organization, but ICs are self-employed. Think of an IC as a separate entity that performs services by agreement for you as one of its clients.

In short, the Internal Revenue Service (IRS) considers someone to be an IC as long as the client has “the right to control or direct only the result of the work and not the means and methods of accomplishing the result.”

If you have the same level of control over the worker that you would expect to have over an in-house employee—not just what they do, but when and how they do it—they’re not an IC. If you purchase services from the worker as you would from a separate business entity, they could correctly be classified as a contractor.

Differences Between Independent Contractor vs. Employee

The most important distinctions that separate ICs from employees are as follows:

  • Who the individual works for: An employee works for you, while ICs are in business for themselves. An IC isn’t part of your company and provides services for other clients.
  • Degree of control: You have more control over an employee than a freelancer. For example, you can assign a shift or work schedule to an employee, while ICs work on their own terms.
  • Whether you provide benefits: You don’t owe a freelancer the benefits that companies are often mandated to provide to employees, including paid time off and employer-sponsored health insurance.

Instead of receiving wages paid by regular paycheck, ICs typically submit an invoice after a project is completed or for a period of work—often, once per month or quarter. Freelancers charge for their work in various ways, from hourly rates to flat per-project rates and even per-piece rates (like a writer charging per word, a video producer charging per clip, or a transcriptionist charging per page).

Your Responsibilities When You Contract Independent Workers Versus Employees

When you hire an employee, you have to adhere to a complex patchwork of labor laws at federal, state, and local levels. These laws stipulate everything from the minimum wage you can pay to how you calculate overtime and whether you have to offer benefits like insurance.

These laws don’t apply to ICs, which means you have:

  • No minimum wage requirement
  • No obligation to pay overtime
  • No responsibility to withhold income taxes, Social Security or Medicare contributions
  • No expenses for benefits
  • No responsibility to pay into unemployment insurance on behalf of the worker

However, you have other responsibilities when you hire a freelancer. These obligations include:

  • Making sure the worker qualifies as an IC under the law
  • Negotiating compensation amounts, work deadlines, and project specifications
  • Specifying these terms in a contract
  • Having the worker fill out the appropriate paperwork, including a W-9 form
  • Paying invoices on time

Is It Better to Hire an Independent Contractor or an Employee?

It may sound like choosing an IC over an employee could save you a lot of money. That’s partly true, but it’s important to understand the big picture. There are pros and cons to hiring both employees and ICs.

Not having to pay overtime, paid time off, health insurance premiums, unemployment insurance contributions, the worker’s portion of Social Security and Medicare contributions, and more employment expenses lightens the cost of hiring an IC. The tradeoff is that you will often have to pay ICs more money than regular full-time employees.

Independent contractors typically set their own rates. Because freelancers are required to pay regular income taxes, self-employment taxes, and have to fund their own health insurance, retirement savings, and other employee benefits, they set their prices at an amount that helps cover these costs.

Additionally, ICs often choose this work arrangement after developing specialized skills or extensive experience. They can charge a premium for these skills because they are in high demand.

Federal and State Regulations on Employees and Independent Contractors

Before you decide whether to hire someone as an employee or a freelancer, consider what the law says. Let’s take a look at:

  • How the IRS classifies contractors
  • How states classify contractors

The Common-Law Test: How the IRS Classifies Contractors

In the 2020 Employer’s Supplemental Tax Guide, the IRS presents a common-law test for worker classification for self-employment taxes and income tax purposes. This test looks at a variety of factors that fit into three main categories:

  • Behavioral control
  • Financial control
  • Type of relationship

Behavioral Control

When looking at behavioral control, the IRS is primarily concerned with the scope of instructions and training that the hiring business provides to the worker.

When you hire employees, you essentially own their time, at least during their scheduled work hours. You control when your employees are on the clock and much more, including:

  • How they do a job
  • Where they perform the work
  • What tools or equipment they use

If you classify someone as an IC, you don’t have this level of behavioral control. Even if you require an IC to be present on-site for some of the work—for example, if this professional is shooting photos or videos at your business address—you don’t decide when and how they perform other tasks involved in the work, such as editing.

If you hire an employee to do this work, you would expect them to complete the task at their desk during normal business hours. You would choose and provide the equipment they use.

A freelancer might prefer to work in the middle of the night or from their front porch. The IC would use their own preferred equipment and their own process and expertise. Although you might be able to request changes and revisions, you don’t have control over how the work is completed.

Financial Control

Some aspects of financial control that point to a freelance consulting relationship rather than an employment relationship include:

  • The IC having business expenses that you aren’t expected to reimburse
  • The freelancer making some investment in their own work, such as purchasing tools, equipment, and software
  • The freelancer advertising or offering their services to other clients besides your company
  • The freelancer being paid for a project or job, rather than a guaranteed wage or salary
  • The freelancer being able to make a profit or incur financial loss

Type of Relationship

If you provide benefits and rely on your worker to perform a crucial part of your business operations on a permanent or long-term basis, you’ve hired an employee—no matter what you call them on paper. The IRS and any states that use similar common-law tests are likely to agree.

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State-Level Laws on Independent Contractors vs Employees

As of 2020, 15 states—plus Washington, D.C.—use the same common-law test that the IRS uses for federal tax purposes. In states that don’t use a common-law test, the most prevalent method of determining the difference between employees and ICs is called the ABC test.

The ABC Test

This three-pronged test sets out criteria that a business relationship must meet for workers to be classified as ICs instead of employees. If any of the requirements aren’t met, the worker must be considered an employee. Certain states, however, use only part of the ABC test—most commonly, the A and C criteria.

Generally, for your worker to qualify as an IC under the ABC test, the following standards must be met, according to the Legal Information Institute at Cornell Law School:

A: The individual you hire to do the work should be “free from the employer’s control or direction.”

B: The freelancer should complete the work in an environment other than your business location, and the work they perform for you should be “outside the usual course of the business” you conduct.

C: The contractor works in an independent business or trade.

The requirements for a worker to be an IC are a lot stricter under the ABC test.

Worker Classification and Contractor Laws Are Constantly Evolving

One of the most important things to know is that worker status laws are still in flux.

For example, California’s state-level law Assembly Bill 5 took effect on January 1, 2020, changing the state’s common-law test to the ABC test. However, Assembly Bill 2257 was passed in September 2020 to add immediate exemptions to the ABC test established by Assembly Bill 5, and potential changes to the law are still under discussion.

Similarly, at the federal level, the U.S. Department of Labor announced on September 22, 2020, that it was proposing a new rule that would “clarify” the distinction of IC versus employee. If adopted, this rule would institute an “economic reality” test that emphasizes how the work relationship operates in practice rather than theoretically.

This rule doesn’t contain any single disqualifying factor. That makes it different—and less limiting—than the ABC test, in which failing any prong prevents a worker from being considered a freelancer.

How to Decide Whether Your Worker Is an Employee or an Independent Contractor

Before you decide whether to hire someone as a contractor or an employee, you must identify which laws are relevant to your situation. That means looking at not only the IRS test but also at what specific tests are used in the state where your business is located and in the state where the freelancer works.

Some states that use all or part of the ABC test interpret and apply these criteria in a much more rigorous manner. Other states are more lenient.

Ask yourself questions like:

  • Are you looking for someone to perform the same job on a consistent and long-term basis (an employee) or perform work on a project-by-project basis (a freelancer)?
  • Do you want to control when, where, and how the individual does their job (employee) or just discuss what you’re looking for and then receive the finished result of their service (freelancer)?
  • Are you looking for someone to become integrated into your business (employee) or someone who brings the specific resources of their own business (freelancer)?
  • Do you expect this person to work for you full-time or as little as a few hours per week, month, or even year? Although freelancers can work full-time or part-time, long-term full-time workers are generally employees.

Figuring all of this out can be complicated. The good news is that you don’t have to guess. At the federal level, you can request that the IRS identify the right way to classify a worker for you by submitting the IRS Form SS-8.

At the state level, you can find out what resources your state labor office provides to help you better understand how to comply with the state’s test. It’s also smart to speak to an employment lawyer who can better advise you on how to correctly set up a contract with a freelancer.

The Implications of Classifying (and Misclassifying) a Worker

In some instances, it’s easy to decide how to classify a worker. Waitstaff and cashiers are usually employees. A graphic designer who creates your menu layout and a marketing consultant who helps you bring in more sales are both likely to be contractors.

What about more complex situations? Perhaps you bring on a part-time worker who works remotely—are they a freelancer because they work off-site and could have another job? Not necessarily.

On the other hand, you could bring on a consultant for a short term project that necessitates temporary full-time hours. Under different state laws, this individual may be your employee, even if your intention was to hire them as an IC.

The implications of classifying someone as an employee are:

  • Spending more money in terms of contributing to social security, Medicare, and unemployment
  • Spending more money to pay for employee benefits
  • Having to abide by labor laws, including those that pertain to minimum wage, overtime, sick time, and health insurance
  • Having to withhold taxes and send the employee a W-2 form at tax time
  • Having a greater responsibility toward that individual as part of your company

The implications of classifying workers as ICs are:

  • Having to make sure the work arrangement can be considered independent contracting
  • Having to send the freelancer a 1099 for income tax purposes
  • Having less control over the work

What Are the Stakes if You Misclassify a Worker?

Classifying workers correctly, especially when you have competing laws to comply with, can be challenging. What if you get it wrong?

First of all, you could have to retroactively pay both the employee’s legally mandated benefits and the employer contribution of their social security and Medicare taxes. This can be a real burden, especially if you weren’t expecting this expense and you already paid a premium wage for the freelancer’s services.

Under the IRS rules, you may qualify for relief provisions which prevent you from having to pay these taxes if you have a “reasonable basis” for considering the contractor independent. However, you have to file paperwork to prove that you had a reasonable basis for your classification of the worker.

In certain states, misclassifying an employee as an IC could get you sued or fined. For example, in California—where the restrictive ABC test makes it difficult for a work arrangement to qualify as independent contracting—a 2011 law called Senate Bill No. 459 allows for fines of $5,000 to $25,000 per violation. Businesses caught routinely misclassifying their employees can rack up astronomical fines.

Conclusion

The high stakes and serious penalties can make you wonder if hiring a freelancer is worth the risk. However, skilled ICs can bring a great deal of value to your business without the added expenses and responsibilities of bringing on full-fledged employees.

The keys to using contractors in your business are understanding what you and the worker want to get out of the arrangement and being mindful of the complex laws that affect how to go about setting up an IC work arrangement the right way.