Independent Contractor vs. Employee: A Guide

At first glance, the difference between a contract worker vs. employee may seem obvious. It’s often easy to distinguish between the two, but gray areas can exist that are important for businesses to clarify. There are federal laws that dictate the differences between a contract employee vs. independent contractor, but companies need to pay attention to state laws as well.

A contract worker (or independent contractor) is self-employed, determines their own rates and availability, and often uses their own equipment. They can work for one employer at a time, or for multiple employers. They’re responsible for paying their own taxes, and for providing benefits such as health insurance and unemployment. Despite the name, independent contractors aren’t legally required to have a contract with their clients. There isn’t a universally agreed-upon legal definition of an independent contractor, but they’re generally understood to be “entities hired by employers to accomplish certain tasks but do not have the right of control over those entities”. The IRS provides a detailed definition of an independent contractor to clarify the difference between a contract worker vs. employee. It’s important to stay compliant with the laws regarding your employees and while it can be tricky, our team is here to help.

An employee, on the other hand, enters into an employment agreement with a business. The employer withholds taxes from each paycheck, complies with minimum wage and overtime laws, and may provide benefits. They’re also in charge of determining the employee’s schedule and what the employee does while they’re on the clock. Just like with independent contractors, there are several ways to outline the legal definition of an employee. However, the general consensus is that they’re “an individual who works under the supervision or control of an employer.” For tax purposes, the employee-employer relationship is thoroughly explained by the IRS.

Understanding Legal and Tax Implications

Tax responsibilities and forms (W-2 vs. 1099)

The IRS requires employers to issue W-2 forms to their employees, and 1099 forms to independent contractors who’ve been paid $600 or more in the past calendar year. In both cases, these documents detail the individual’s annual earnings from the employer.

The IRS requires employers to give each employee their W-2 form for the last year by January 31^st (this applies to both current and former employees). In addition to detailing how much the employee was paid in wages, tips, bonuses, etc., Form W-2 also specifies the amount of federal, Medicare, and Social Security taxes were withheld. Since this form is a major factor in correctly filing a tax return each year, it’s important to double-check that everything is correct. If an error is spotted, the employer should issue a corrected Form W-2, which is called Form W-2c.

Form 1099 is sent by employers to independent contractors. There are actually several different types of 1099 forms; the type of Form 1099 that’s issued depends on the classification of the independent contractor. For example, people who work in construction, design, media, or maintenance roles (among others) would be likely to receive a Form 1099-NEC. As mentioned above, the threshold for sending a 1099 form is $600 in a year. In contrast to Form W-2, the IRS deadline to send Form 1099 depends on the type of Form 1099 that’s used.

Consequences of misclassification

There can be significant risks in misclassifying a contract worker vs. employee. It doesn’t matter if an independent contractor is “misclassified” as an employee, since they’re effectively just being made employees rather than contractors. The danger lies in misclassifying an employee as an independent contractor, either by mistake or in an effort to avoid paying for employee taxes, benefits, unemployment, and so on. This can result in fines from the IRS or the Department of Labor, as well as increased scrutiny to ensure future compliance. 

Employers may also be required to compensate employees for the benefits they should have received while being incorrectly classified as contract workers. These benefits could include back wages (including unpaid overtime), retroactive health insurance or workers’ comp, vacation or sick leave, or the employer’s share of payroll taxes. This can constitute a significant financial hit for the employer, especially if the employee decides to file a lawsuit against their employer. In other words, the consequences of misclassification can be severe; hiring an expert to ensure compliance is a better option than risking an IRS audit, fines, or retroactive payments.

IRS guidelines: behavioral, financial, and relationship factors

The IRS describes three “common law rules” to help people determine the difference between a contract worker vs. employee.

• Behavioral: does the business determine (or have the right to determine) the worker’s job and how it’s performed?
• Financial: does the payer control business aspects of the worker’s job? (Including how they’re paid, deciding who provides materials or equipment, whether expenses get reimbursed, etc.)
• Type of relationship: Does the worker get benefits like health insurance or paid vacation? Is there a written contract? Is the relationship ongoing, and is the job an integral part of the business?

Common state-level considerations

State labor laws can vary widely from one state to the next. Each state can determine their own minimum wage, tax reporting procedures, pay frequency, and much more. An example of this is Georgia’s minimum wage, which is $5.15/hour. Most businesses in Georgia adhere to the federal minimum wage of $7.25/hour, but there are some exemptions in which the state minimum wage can be applied. Another example is found in Georgia’s pay frequency law, which requires employers to pay employees at least twice per month. This is in contrast to federal law, which doesn’t specify a frequency at which employees should be paid.

Key Differences Between Independent Contractors and Employees

Payment structures and invoicing

Employers approach payments to a contract worker vs. employee very differently. For an independent contract, the contractor sends an invoice that includes:

• The total amount due
•  A breakdown of the total, including expenses, hours worked, etc.
• The payment deadline
• The preferred payment method, if applicable

Employees get paid on a set schedule that’s determined by the employer. This usually happens every two weeks, but it can vary from company to company. Employees can be paid in various ways, usually by check or bank transfer. Regardless of how they’re paid, workers should receive a paystub that specifies:

• The total amount paid
• Withheld taxes (federal, Medicare, and Social Security)
• Hours worked (if applicable)
• Any other types of income (such as tips or bonuses) that were received during that payroll period

Autonomy and control over work

Contract workers are in charge of managing their own schedules, which means they can choose when they work, as well as which projects they take on. This is an advantage for people who want to maintain a flexible work schedule, and gives them more room to scale their job commitments up or down as needed. The downside is that they aren’t guaranteed a certain amount of work. Rather, they’re responsible for finding their own clients, and may not always have as much work as they’d prefer.

Employees are usually hired to fill a specific position; the employer determines when the employees work, and which tasks their employees work on. Some employers are flexible about when their employees work, while others maintain a strict 9-to-5 schedule. Regardless, in an employer-employee relationship, the employer gets final say over the employees’ work schedule.

Benefits and protections

Even though independent contractors don’t get benefits from their employers, they do enjoy other advantages. As an example, they’re free to hone their expertise and target specialized markets – the contract worker equivalent of a promotion and a raise. Although this isn’t always possible for all independent contractors, the option is always there if the opportunity presents itself. However, contractors receive very little in terms of protections from employers. They aren’t entitled to workers’ comp or unemployment, and they can’t sue for wrongful termination. That being said, they are legally entitled to sue for breach of contract if an employer refuses to fulfill the terms of a written contract.

Employees are legally entitled to certain benefits and protections, and optional benefits may be provided by the employer as well. Legally required protections include things like minimum wage, higher rates for overtime, workers’ comp, unemployment, and more. Another key difference between a contract worker vs. employee is that employers pay 50% of employees’ income tax, Medicare, and Social Security tax. Some employers decide to provide benefits like paid vacation, paid sick leave, paid maternity leave, training programs, and opportunities for career advancement. Optional benefits are usually offered as an incentive to attract top-tier talent, or to improve employee satisfaction and retention. 

Nature and duration of work

When negotiating an independent contract, the contractor and the employer should either agree on a start and end date, or agree to leave the contract open-ended. As an example, an independent contractor with a carpentry business could agree to make a table to a client’s specifications, but set a deadline that’s two weeks later than the client asked for. The client can either agree, or find another contractor who can do the job more quickly. On the other hand, an independent contractor who works as a fitness coach could take on clients as availability permits. Some clients may only complete a couple of sessions, while others could stay for months or even years.

In contrast, employees can’t unilaterally decide when to work and what to work on. This is typically decided by the employer, although they may be open to scheduling employees based on their availability. Employees can leave their job for any reason, and federal law doesn’t require them to give advance notice. Employers can terminate an employee for any reason and without advance notice – with some exceptions. If an employer fires someone based on their race, religion, sex, gender identity, national origin, age, or disability status (among others), they could be sued for wrongful termination. In some cases, the employment contract may add other limitations to the employer’s ability to terminate at will.

Making the Right Choice for Your Business

Aligning classification with business goals

Regardless of the size of a business, employers often decide between a contract worker vs. employee based on the position that needs to be filled. If an employer is looking for both a landscaper and a regional manager, the landscaper would probably be a contractor and the regional manager would almost definitely be an employee. Why? Because an independent contractor with expertise in landscaping could play an important role in the company’s image, but their work performance wouldn’t benefit from an intimate knowledge of the company’s ethos. However, a regional manager would most certainly need to know the ins and outs of the business in order to be effective, so it would make more sense for them to be an employee.

Weighing flexibility vs. security

Since there are fewer legal requirements when hiring or terminating a contract worker vs. employee, employers have more flexibility when working with independent contractors. The flip side of the coin is that contractors are less likely to feel loyalty towards the employer, since they may work for multiple clients each year. Hiring an employee is more of a legal commitment for an employer, but it’s also a bigger commitment for the employee than it is for a contractor. Employees tend to have a better knowledge of the company culture and internal processes, and typically don’t need to be replaced frequently if they’re hired for the long-term.

Incorporating specialized skills

Independent contractors are often preferred over employees if specialized skills are needed, especially for small- or medium-sized companies. Employees may not have the chance to specialize in a certain niche, but contractors are motivated to do so because this can help them stand out to potential clients.

FAQs for Independent Contractors vs. Employees

What are the consequences of misclassifying a contract worker vs. employee?

If an employer is found to be misclassifying employees as contract workers, they could be required to retroactively reimburse employees for unpaid overtime and benefits, as well as pay fines imposed by the IRS or Department of Labor. This applies whether the misclassification is accidental, or on purpose to avoid paying taxes and employee benefits.

What happens if a contract worker is hired as an employee?

There are no legal consequences for hiring someone as an employee when they could have been a contract worker, since this doesn’t result in unpaid taxes and fewer benefits for the employee. When discussing the potential misclassification of worker vs. contractor, the federal government is mainly concerned with employees that are misclassified as independent contractors.

What are the benefits of hiring employees?

Employees tend to identify more with the company they work for compared to contractors, since they don’t frequently switch from client to client. If the employer needs people to work overtime, they have more say in scheduling overtime hours. Plus, most employees get paid a higher rate when working overtime (there are a few exceptions for salaried employees). Employees can also be asked to fill a different role if needed, something that contractors may not even agree to do.

What are the benefits of hiring independent contractors?

A worker who’s hired for an independent contract is more likely to specialize in their niche, bringing a level of expertise to projects that employees may not have. While independent contractors set their own rates and schedules, employers don’t have to withhold taxes, pay for overtime, or provide benefits like health insurance and unemployment. When comparing a contract worker vs. employee, hiring and dismissing a contractor is a much simpler process.

Can independent contractors be hired without a contract?

Yes, they can; this usually depends on the type of independent contract and on the contractor. If the project is smaller (or takes place in increments), and the contractor decides that the risk of not being paid is low, then the absence of a contract isn’t necessarily an issue. In this case, there’s typically a verbal agreement in place of a written one, so each party knows what to expect.

How can a business ensure they correctly classify a contract worker vs. employee?

The IRS has published guidelines on how to distinguish between a contract worker vs. employee. However, it can still be tricky to use these guidelines accurately, which is why it’s recommended to consult a payroll expert. They can ensure that each person is correctly classified, and minimize the risk of misclassifying a worker vs. contractor.