Difference Between Independent Contractor and Employee
Classifying Workers - Why it Matters
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 and Independent Contractors – Definitions
Employees (sometimes called common law employees) are individuals who works for an employer that controls the work of the employee – what will be done and how it will be done.
Independent contractors are professionals or workers who are in a trade or business offering their services to the general public. People like doctors, dentists, building contractors, and freelancers are considered independent contractors. Independent contractors are considered to be self-employed and their earnings are subject to self-employment tax (Social Security and Medicare).
Why Worker Status is Important
Determining whether a worker is an independent contractor or an employee is important because it determines whether payroll taxes (income taxes and FICA taxes) are withheld from the person's payment. You must withhold payroll taxes from employee pay, but you don't withhold taxes from payments to independent contractors.
How the IRS Determined Worker Status
There is no overall one-shoe-fits-all way to know if a worker is an independent contractor or employee. The IRS looks at each situation on a case-by-case basis. But there are some guidelines the IRS uses. You can use those guidelines to see how your workers might fit into one or the other category.
To help distinguish between employees and independent contractors, the IRS has set up three general criteria:
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 their own hours and works with little or no direction or training, they are probably an independent contractor.
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, they are probably an employee. For example, a maintenance worker would not be doing 'company' work if they were working for a bank.
The IRS looks at employee vs. independent contractor designations on a case-by-case basis. They assume the person is an employee.
Getting a Worker Status Determination
It is sometimes difficult to determine the status of a worker, but if you are unsure, assume the worker is an employee in the eyes of the IRS. If you want to find out whether to classify a worker as an independent contractor or employee, you can file a Form SS-8 to request a determination from the IRS. The IRS doesn't issue determinations on hypothetical situations, but only for in order to resolve federal tax matters.
Another Possible Status for Workers
Just to confuse things, there is another possible status for workers, called a statutory employee (or non-employee). A statutory employee is a cross between an employee and an independent contractor; they are treated as a worker outside the company, but they are treated as an employee for employment tax purposes and like an independent contractor for income tax purposes.
Only four specific categories of workers can be designated as statutory employees:
- Some drivers who distribute (non-milk) beverages, meat, produce, or bakery products, if they are agents of your company and paid on commission.
- Full-time life insurance agents selling insurance primarily for one company
- Piece workers who work at home on materials or goods you supply. You specify the work to be done and the goods or materials are returned to you.
- A full-time traveling or city salesperson, if the work performed for you is this person's principal business. The person turns in orders to you and the goods sold must be merchandise for retail or supplies used in the buyer's business.
How Employees and Independent Contractors Pay Taxes
Employees are paid as salaried or hourly, on commission, or a combination, and may be subject to overtime. Employees are taxed on their income, and 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 unless they are subject to backup withholding.
Your business also isn't required to make payments for Social Security and Medicare for independent contractors. The independent contractor must pay these Social Security/Medicare taxes as self-employment taxes on the payments they receive.
You must send each independent contractor an annual 1099-NEC form (beginning in 2020) if you paid that person $600 or more during the year.
Employees and Independent Contractors and Labor Law
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 contractors or employees for purposes of the labor law (Fair Labor Standards Act). 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 others 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
IRS. "Employee (Common-Law Employee)." Accessed May 7, 2020.
IRS. "Independent Contractor Defined." Accessed May 7, 2020.
IRS. "Understanding Employee vs. Contractor Designation." Accessed May 7, 2020.
IRS. "Instructions for Form SS-8." Accessed May 7, 2020.
IRS. "Statutory Employees." Accessed May 7, 2020.
IRS. "About Form W-2, Wage and Tax Statement." Accessed May 7, 2020.
U.S. Department of Labor. "Independent Contractor." Accessed May 7, 2020.