Differences Between Employee and Independent Contractor

If you’re a business owner, you’ll likely come to a point where you need help. Whether you need someone with different skill sets to handle specific tasks or don’t have enough time to finish your work, hiring someone is a great way to grow your business.

When bringing on help, you can hire a full-time employee, part-time employee, or contractor. Employees and independent contractors can help grow your business, but solopreneurs must understand how they differ and how those differences impact their small business.

Defining an employee vs. a contractor

Employees and contractors are people that you pay to help you with your business. However, it’s important to understand the difference because your responsibilities as a business owner will vary depending on which path you take.

The IRS offers some guidance to help determine if an individual should be considered an independent contractor vs employee. There are three categories to consider to ensure you are in compliance with federal and state law and don’t encounter issues with misclassification between these types of workers. 

Behavioral 

What degree of control does the employer have? Does the employer control the type of work the worker does, when the work occurs, and how the worker does their job?

Here’s an example: Jane hires John to work in her food truck. He must work at whatever location the food truck is on that day and has a shift from 9 a.m. to 5 p.m. daily. Given that Jane determines John’s working hours and location and his work pertains to the key operation of the business, he is likely an employee.

Financial

Are business aspects like how the worker receives payment, whether they receive reimbursement for their expenses, or whether the employer provides the necessary equipment controlled by the employer? If the answer is yes, the worker is an employee.

Here’s an example with Jane and John: If Jane provides John with the tools he needs to complete his work and she pays him weekly on a normal cadence, John meets the financial category classification to be an employee.

Type of relationship

Employees enter into an at-will employment written contract, allowing either party to terminate the relationship legally. Contractors or freelancers, on the other hand, sign agreements with specific terms and deliverables, and failure to adhere to the contract may lead to legal consequences. 

Employees often have a long-term impact on the company, working regularly for months or years, while contractor agreements are typically short-term, focusing on specific tasks or projects.

For example: Jane decides to rebrand her food truck with a new design and logo. She hires Jim, a graphic designer, to draw up a new design for her truck and help create a new logo. She gives Jim a deadline but doesn’t tell him when to do the work or where to do it. Jim uses his own tools to make the design and gets paid once he delivers the design files to Jane.

Jane isn’t controlling Jim’s working hours, where he works, or how he works. The work isn’t directly related to the business’s ongoing operations. There isn’t an expectation of long-term employment, so Jim is likely a contractor.

Another way of thinking about it is that employees like John often don’t or aren’t expected to have a second job unless they work part-time. Self-employed individuals like Jim usually work for multiple businesses at the same time.

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Tax treatment of employees vs. contractors

The tax reporting, financial obligations, and duties of an employer change drastically when employing full-time employees vs. contractors. One key difference is your business’s payroll tax obligations. In short, you have more responsibility and more costs for employees than contractors. 

Tax obligations for employees

Employees are on your payroll, meaning you must pay employment taxes and compensate them on a set schedule. Plus, you might need to use a payroll software program like Gusto, which is an extra cost for your business.

Beyond that, you are also responsible for withholding tax from their pay. This means withholding income tax and paying into payroll taxes such as Social Security taxes and Medicare taxes.

An employer may also offer employee benefits, including health insurance, vacation pay, or a retirement plan, which are more costly for the employer, but become deductions for the business. In some states, employers are required to provide employees with certain benefits. 

At the end of the year, you’ll need to report payments to your employees to the IRS and send Form W-2 to your employees. You can deduct the amount you pay employees as a business expense.

Tax obligations for contractors

Contractors may be paid on an hourly or per-project basis. While you do have to determine how you pay your contractors (PayPal, Venmo, paper check), you aren’t responsible for withholding taxes or setting them up on a formal payroll schedule. A contractor or freelancer is considered self-employed and responsible for their own taxes, so you do not have to cover payroll taxes on their behalf. 

In addition, contractors aren’t entitled to some of the same employment benefits employees receive, like health insurance or retirement matching. However, it’s likely a contractor is able to take deductions for certain business expenses, while employees cannot typically claim deductions for expenses incurred as an employee. For example, a contractor would be able to deduct the cost of their home office space or work-related travel, while these expenses are not deductible as a regular employee.

At the end of the year, you need to report payments to your contractors to the IRS. You’ll also need to report payments to the payment recipients by sending them Form 1099-NEC. As a business owner, you can deduct the amount you pay contractors as a business expense.

Risks of misclassifying employees as contractors

Misclassifying an employee as a contractor is a common mistake and can expose you to significant penalties. While the IRS imposes specific guidelines on what constitutes an employee vs. contractor, certain states have their own unique rules on classifying members of your team. 

For example, if a contractor is improperly classified and should have been an employee, both the IRS and state tax authorities could impose retroactive payroll tax, with penalties and interest added. 

Beyond that, you may incur fines for misclassifying an employee as an independent contractor. For example, in California, you could be fined up to $15,000 if a court or the Labor and Workforce Development agency determines you’ve misclassified an employee as a contractor.

Legal responsibilities and protections

Your legal responsibilities toward your workers and the protections they receive under the Department of Labor must be in line with both federal and state labor laws.

Employees often have more legal protections than contractors, and you have more responsibilities toward them. Under the Fair Labor Standards Act, employees must receive minimum wage and, in some instances, are required to receive overtime pay. On the contrary, employment law does not require the same protection to be offered to contractors or freelancers. 

If the lines between contractor and employee are blurred, you may end up in a situation where you should classify the contractor as an employee. This could mean you’d be responsible for paying for benefits like health coverage.

Choosing the correct worker status for anyone associated with your business is critical to avoid any situation where the line between employee and contractor could get blurry.

The bottom line

Hiring an employee or contractor can help your business grow, but understanding the differences is essential. Accurate worker classification can help you avoid significant legal and tax liabilities while running your own business smoothly.