A Small Business Guide to Independent Contractors vs. Employees

Independent contractors and employees receive different treatment, from taxes to fringe benefits. The Ascent shows you how to correctly classify your workers.

The independent contractor vs. employee debate is about as hot and steamy as the tax world gets.

Most of the time, it’s easy to discern an independent contractor from an employee. However, sometimes the nature of a worker’s role lies in a gray area between the two classifications. If that’s why you’re here, read on.

Behavioral control, financial control, and the worker-business relationship set independent contractors and employees apart. Image source: Author

What is an independent contractor?

Independent contractors provide their services to clients for a fee. Businesses bring on independent contractors to complete projects that require capacity and expertise not found in their workforce.

For small businesses, two of the most common types of independent contractors are lawyers and accountants. Since their services aren’t constantly needed, it’s more cost-effective to pay them only when you need their expertise.

When a business engages an independent contractor, they usually put together a contract to establish the fee and the desired work output. Independent contractors generally have the flexibility to decide how, where, and when they work.

Independent contractors are self-employed. Businesses withhold no taxes from their contractors’ fees because independent contractors pay and file their business taxes.

What is an employee?

Businesses hire employees to perform services for either hourly or salaried compensation. They’re usually required to work within set hours, and their employer can dictate how and where they execute their duties. Employees can be hired in part-time or full-time capacities.

Employees, also called common-law employees, earn regularly scheduled paychecks. Their employer must withhold a portion of employees’ paychecks for Federal Insurance Contribution Act (FICA) taxes, state income tax, and federal income tax.

Businesses may decide how their employees work, but with that ability comes more rules about how they’re treated. More on that later.

Independent contractor vs. employee: What's the difference?

Three categories set employees apart from contractors: taxes, control, and benefits.

1. Taxes

From a small business tax perspective, there’s a stark difference between hiring a contractor and hiring an employee.

For the most part, it’s a breeze to pay contractors: Have them fill out a Form W-9 and send them a check, taking out no taxes. Every January, you issue a contractor tax form Form 1099-NEC to every contractor you paid $600 or more during the previous year.

In rare circumstances, you might encounter a contractor who requires backup withholding, in which case you must withhold and remit to the IRS 24% of the contractor’s fee. The IRS requires backup withholding when an individual either doesn’t report income, underreports income, or fails to provide a correct taxpayer identification number (TIN) to a previous client.

Independent contractors, also called contract employees, must pay all taxes on their own. In addition to state and federal income taxes, they pay self-employment taxes equal to the employee and employer portions of FICA taxes. Tax software makes it easy to keep up with all of these payments.

When it comes to employees, businesses have more tax responsibilities. Employers must withhold a portion of employees’ paychecks to cover FICA taxes, state income tax withholding, and federal income tax withholding. Employees must submit a Form W-4 to tell their employer how much to withhold for federal income taxes.

Each January, businesses issue Form W-2 to each employee and the Social Security Administration (SSA) to summarize wages and tax withholding.

Businesses also pay employer-paid payroll taxes, such as federal unemployment taxes (FUTA), state unemployment taxes (SUTA), and the employer portion of FICA taxes.

2. Control

Businesses can exert more control over their employees’ work than independent contractors’.

W-2 employees customarily work in their employers’ offices and must be present during set work hours. Independent contractors are less likely to be required to work from their clients’ offices -- unless the work needs to be done there -- and might not be tethered to working at specific hours of the day.

Businesses can also control how employees perform their assigned work, but that’s not the case for independent contractors. When you bring on contract labor, you’re relying on their expertise to complete the project, and you can’t dictate a play-by-play for getting it done.

3. Benefits and protections

The most noticeable difference between contractors and employees pertains to benefits and protections. Employees are often afforded more opportunities than independent contractors, making them more expensive hires than contractors.

For one, employees are protected under the Fair Labor Standards Act (FLSA), which requires time and a half overtime pay. Also, employees must earn at least the state minimum wage. Overtime and minimum wage laws don’t apply to independent contractors.

Also, the Affordable Care Act (ACA) requires that businesses with 50 or more full-time equivalent (FTE) employees must offer affordable health insurance coverage for full-time employees and their dependents. Independent contractors usually have to fund their own health insurance plans.

Employers entice top talent with company-provided perks, such as paid vacation and retirement contribution plans. Independent contractors are self-employed and fund their own perks packages.

Last, employees who lose their job due to no fault of their own can receive unemployment benefits, which compensates them while they seek new work. Independent contractors usually aren’t eligible for unemployment compensation, yet they also don’t pay federal or state unemployment taxes.

What are the IRS criteria to correctly classify a worker?

The IRS looks at behavioral control, financial control, and the worker-business relationship to classify a worker properly.

1. Behavioral control

Behavioral control is all about how much influence a business has over the services the worker provides.

• Instructions: Businesses and their independent contractors should agree on the quality and nature of a finished work product, but contractors play by their own rules to get the project done. They can’t be told how to complete the product or what tools to use.
• Training: Businesses often provide training to their employees. Independent contractors typically don’t receive training from clients on how to do their job. If you’re a professional baker, and a client gave you the gingersnap recipe you should follow, that’s a faux pas.
• Evaluation: You can evaluate a contractor’s finished work but not the intermediary steps. Businesses can and should check in periodically with employees to assess their progress at a reasonable interval.

Example: Grubhub famously won a case in 2018 that allows its delivery drivers to remain classified as independent contractors. A TechCrunch report points out that because the company has little control over how drivers perform deliveries and at what times, they are considered independent contractors.

Take these examples with a grain of salt: California’s 2020 ruling that rideshare drivers must be considered employees appears to counter the ruling in the Grubhub case. These rules are still somewhat ill-defined.

2. Financial control

Independent contractors are business owners, meaning they set their fees and can have more than one client at the same time. When you interfere with the financial side of an independent contractor’s business, you’re crossing the independent contractor-employee line.

• Equipment: You can provide independent contractors with proprietary equipment to complete a job, but contractors mostly pay for and use their own equipment to complete the job. Plumbers bring their own tools to the job, but you might provide them with a special wrench for your special faucet, for example.
• Business expenses: While not always a legal requirement, employees should be reimbursed for expenses they incur on behalf of the business. Independent contractors, on the other hand, tend to incur more unreimbursed business expenses. Contractors can deduct those costs on their business taxes.
• Opportunities: Independent contractors have the flexibility to juggle multiple client projects simultaneously. When you start requiring exclusivity from contractors, you’re wading into employee territory.
• Pay schedule: A person paid hourly or weekly is most likely an employee. Contractors receive a flat fee for each completed project.

Example: Your business pays a lawyer by the hour to review your contracts. Though the lawyer is paid hourly -- an indicator of an employee relationship -- the lawyer is still an independent contractor because he or she can take on multiple clients at the same time and likely doesn’t receive consistent work from you.

3. Worker-business relationship

Be precise in how you word worker agreements. Make sure these contracts address the following areas:

• Worker status: When you’ve decided the worker classification for the position you’re hiring, clearly define it in the contract.
• Benefits: You can offer employees perks, such as paid sick leave and health insurance, but those are off the table for independent contractors.
• Permanency: While most employment agreements are at will, there’s an expectation that employees stick around for an indefinite amount of time. When you bring on an independent contractor, define their project assignment explicitly.
• Services provided: An employee’s role should be seen as something essential to the business's core function, and independent contractors should come in to provide expertise or a service outside the ordinary course of business.

Example: T-Shirt Cornucopia is looking for someone to design a new logo for their online store. Since logo design is a once-in-a-while project, the company could reasonably bring on a 1099 independent contractor to create the design.

What are the consequences of misclassifying an employee?

At first glance, it might seem like the difference between an employee and independent contractor is cut-and-dry, but there’s a lot of gray area. Businesses of all sizes leverage independent contractors, and tech giants like Uber and Google have come under fire for misclassifying workers as contractors instead of employees.

The consequences can be grave when you intentionally misclassify a worker. You’re looking at criminal charges and penalties of up to $1,000 per worker.

Intentional or accidental, you’ll be required to make up the lost tax revenue when you misclassify a worker as an independent contractor who should be an employee.

Still don’t know? The IRS can tell you

If you’ve read this article and still aren’t sure how to classify a worker, file Form SS-8 with the IRS. You can expect a response within about six months of submission with a decision on how to classify workers. While you wait, consult a tax or legal professional.