Do you know difference between an employee and independent contractor?
As you grow your business, understanding the distinction between these two terms will be critical.
Hiring an employee vs. an independent contract comes with a unique set of pros and cons, especially when it’s time to file your business taxes.
So, what’s the difference between an employee and an independent contractor? And why is it important to categorize the people who work for you correctly?
Keep reading for our rundown.
Many people think they have a choice when deciding whether to pay a worker as an employee or an independent contractor, but that isn’t the case at all.
Legally, there are big differences between an employee and an independent contractor—the most important difference is in the withholding and payment of employment taxes.
Because of the fact that payments to independent contractors aren’t subject to employee withholdings or employer paid taxes, some business owners prefer hiring workers as independent contractors rather than employees. But they must use caution, because in order to pay a worker as an independent contractor, several standards must be met.
Keep in mind that paying someone as an independent contractor when they are really an employee is illegal and can be costly.
Common law rules outline the difference between an employee and an independent contractor. Generally, a worker is an employee if:
Generally, a worker is an independent contractor if:
Let’s look at a couple of examples so you can see difference between an employee and an independent contractor.
Joyce is a marketing professional who works around 15 hours per week for Company A providing social media and other marketing services. She works out of her home and pays all of her own business expenses including the cost of the applications and tools she uses to promote Company A. Joyce charges Company A an hourly rate for her services and provides similar services to Companies B and C.
Joyce meets all of the tests to be classified as an independent contractor because she controls how, when, and all the other details of how the work is performed for Company A. She also pays for her own business expenses and provides the same services to other companies.
Laura is also a marketing professional who works for Company A about 15 hours per week. She writes articles and other marketing materials that are used in advertisements and social media campaigns. Laura performs her work onsite at the Company A office using their computers and other office resources and reports to the VP of marketing. She’s also paid an hourly rate for her services and doesn’t provide marketing services to anyone else.
Laura does not meet the tests to be classified as an independent contractor because even if she has freedom of action with her job, she is using Company A’s resources and has someone overseeing when and how she performs her work. Another determining factor is the fact that she doesn’t provide her services to the public, only to Company A. Based on the circumstances, Laura should be classified as an employee of Company A.
These two scenarios were pretty straight forward and clearly illustrate the difference between an employee and an independent contractor, but sometimes the facts aren’t so cut and dry.
Let’s take a look at a third scenario:
Tim works as a landscaper for Company D about 15 hours per week, performing work for clients of Company D as directed by the owner. He uses mowers and other equipment provided by Company D to complete his work and is paid hourly for his services. Company D also reimburses Tim for mileage and other expenses for using his personal truck to complete the work. Tim also works for Company E providing landscaping services directly to them, but uses his own mower and equipment to complete that work.
Tim is an employee of Company D because he does not meet all of the common law rules to be an independent contractor. Even though he provides the same type of services to Company E, Company D provides Tim with the equipment used to do the work for their clients and dictates when and how the work should be performed. Company D also reimburses Tim for his mileage and vehicle costs, which is typical of an employer/employee relationship.
Based on the above scenario, Tim may be classified as an independent contractor by Company E if he meets all the required common law rules.
This is where it’s critical to understand the difference between an employee and an independent contractor.
According to the IRS, “There is no ‘magic’ or set number of factors that ‘makes’ the worker an employee or an independent contractor, and no one factor stands alone in making this determination. Also, factors which are relevant in one situation may not be relevant in another.”
Many businesses mistakenly believe this means they have some “wiggle” room in determining how to classify their workers, but this just isn’t the case. In fact, misclassifying workers can be costly. If you pay a worker who should be an employee as an independent contractor—and have no basis for it—you might be held liable for employment taxes for that worker along with interest and penalties.
The IRS has a webpage dedicated to this topic to help you determine the difference between an employee and an independent contractor.
If you’re still in doubt, you can file a Form SS-8, which describes the nature of the relationship between the payer and worker, and the IRS will review the facts and circumstances and give you an official determination of the worker’s status. This process can take up to six months to complete but may be well worth the effort if you hire lots of workers who perform the same types of services under the same circumstances.
As you grow your business, it’s critically important that you understand the difference between an employee and an independent contractor. Take the time to absorb the various distinctions, and make sure you categorize the people who work for you correctly.