Difference Between Independent Contractor and Employee
Classifying Workers - Why it Matters
Why Is It Important to Know if Workers are independent contractors or employees?
The distinction between employees and independent contractors is important. The status of someone who works in your business makes a difference in how you pay them and in how they pay taxes.
Employees are paid as salaried or hourly and may be subject to overtime. Employees are taxed on their income (they receive a W-2 form showing their annual income), and you must also withhold federal and state income taxes and FICA taxes (Social Security and Medicare) from them. Your business must also make FICA tax payments.
If someone is working for your business as an independent contractor, you don't withhold federal or state income taxes and FICA taxes from the amounts you pay them. Your business also isn't required to make payments for FICA taxes. The independent contractor must pay his or her own income taxes (called self-employment taxes), along with income tax on earnings.
How do I know if a worker is an Independent Contractor or an Employee?
The IRS distinguishes between an independent contractor and an employee for the purpose of payroll taxes and withholding taxes. Basically, an independent contractor is an independent business person who runs his or her own business but who does work for another business. An employee is hired by a company to perform specific work at the direction of the employer.
How Does the IRS Decide a Worker's Status?
To help distinguish between employees and independent contractors, the IRS has set up three general criteria:
- Behavioral Control
- If an employer trains and directs work, including hours of work, what tools or equipment to be used, specific tasks to be performed and how the work is to be done, the worker is likely an employee. If the worker can set his or her own hours and works with little or no direction or training, he or she is probably an independent contractor.
- Financial Control
- This factor includes how the worker is paid, whether the worker may work for others at the same time, and whether the worker can incur a profit or loss. A worker who is paid a salary is restricted from working for others, and who does not participate in company profits or losses, is probably an employee.
- Type of Relationship
- The presence of a specific contract may indicate an independent contractor, but this factor alone is not controlling. If the worker is entitled to benefits, this would indicate an employment relationship. Another factor would be the type of work the person does; if it is directly related to the company's core work, he or she is probably an employee. For example, a maintenance worker would not be doing 'company' work if he or she were working for a bank.
The IRS Always Assumes Workers Are Employees
It is sometimes difficult to determine the status of a worker, but id you are unsure, count on the worker being an employee in the eyes of the IRS. If you are unsure whether to classify a worker as an independent contractor or employee, you can file a Form SS-8 (PDF) to request a determination.
Supreme Court Decisions Relating to Independent Contractor Status
The Department of Labor relies on Supreme Court decisions on independent contractors. These decisions reveal that there is no one single rule or test for independent contractor or employee for purposes of FLSA. The Court has held that it is the total activity or situation which controls. Among the factors considered significant are:
- The extent to which the services rendered are an integral part of the principal's business
- The permanency of the relationship
- The amount of the alleged contractor's investment in facilities and equipment
- The alleged contractor's opportunities for profit and loss
- The amount of initiative, judgment, or foresight in open market competition with other required for the success of the claimed independent contractor.
- The degree of independent business organization and operation.
Other factors deemed immaterial to the question:
- The place where work is performed
- the absence of a formal employment agreement
- whether the alleged independent contractor is licensed by the state/local government
- the time or mode of pay does not control the determination of employee status.