Independent Contractor vs. Employee: 5 Key Differences

As a startup, you’re all about staying lean and flexible. You’ve done your research and are considering hiring an independent contractor. You might have to hire an international contractor, or find someone that is willing to complete a short-term project. In any case, it can be tricky to classify independent contractors vs employees correctly.

But navigating the differences between contractors and other types of workers is critical for your company's success. Misclassified workers on your payroll can lead to tax penalties, payment errors, and legal problems. It can also damage trust with your staff and investors.

Within your business entity, understanding worker classifications allows you to recruit new workers without hiccups. It also helps you be transparent with your individual workers. In this guide, we'll dive into the most important factors to consider when determining employment status.

Why are the differences between independent contractors vs. employees relevant?

Local, state, and federal agencies regulate payroll taxes and enforce employee legal protections. As an employer, you're responsible for understanding the legal differences between independent contractors vs employees. You also have to classify each individual worker's employment status correctly.

Accurately classifying your workers' employment status will save you from costly tax and legal violations. You'll also maintain a trustworthy reputation, avoid contract disputes, and nurture positive relationships with your staff.

Key factors in determining worker classification

Government agencies look at multiple criteria when determining a worker's legal classification. A contractor can check multiple boxes for an employee and still be independent, for example.

1. Control and independence

The amount of control you exert in the working relationship plays a significant role in determining employee status.

Independent contractor status places a worker in the same position as any other vendor. They provide a product or service in a mutual business relationship based on an independent contractor agreement. You might agree on requirements, such as how to deliver documents or when they should submit projects. Outside of this contract, you have limited power over how, when, or where they work.

In contrast, a formal employment agreement allows you to control details such as hours, location, and even attire. While the employee consents to this agreement, the employer usually sets all terms.

2. Nature of the work

Employees handle essential business operations and can have a variety of duties. Independent contractors work on specific projects or within a limited scope. You might hire a contractor to create a website, review documentation for errors, or implement a software upgrade. The work is often essential but not integral to daily business operations.

The following scenarios are typical when it comes to an independent contractor's responsibilities:

• Large organizations commonly hire outside vendors to do this type of work.
• The work is specialized or different from what regular employees are doing at your company.
• The worker is filling a temporary need.

3. Relationship and benefits

Businesses don't provide independent contractors employment benefits such as retirement plans or health insurance. Also, contractors aren't eligible for workers' compensation and pay their own employment taxes.

Traditional employees have various compensation benefits, such as employee reimbursements for job-related expenses. Contract workers should account for regular business expenses in their invoiced rate, not as a reimbursement. To avoid ambiguity, don't supply a contractor with equipment you wouldn't provide another vendor.

To avoid further confusion between reimbursing employees and contractors, you can use purchase orders for non-employees. This should only apply to tangible purchases, not expenses like travel or mileage. The purchase order should clearly outline what you are buying and how it aligns with the independent contractor agreement.

4. Financial and business aspects

Your employees rely on you as their sole income source. You don't have the same financial control over an independent contractor. Instead, you're their customer, and they're selling you a product or service.

For instance, an investigator looking for classification issues will be interested in whether you set wages and hours. They might also look at how closely your relationship with the contractor resembles that of a regular employee.

Here are some of the typical characteristics of an independent contractor:

• They work for multiple companies or organizations.
• Their work with you only takes up a portion of their full-time working schedule.
• The contract sets a precise time frame or scope of work.
• They have a significant investment in their business and working materials.

Also, consider whether you offer employee equity as compensation. Compensation benefits such as equity typically indicate either an employment relationship or partnership.

5. Legal and regulatory compliance

You must follow different rules depending on whether a worker is an independent contractor vs an employee. You have more liabilities for employees than non-employees.

You must withhold payroll and income taxes for employees, such as Social Security and Medicare. Employees also have legal protections related to minimum wage, worker's compensation, employee benefits, and sick days.

Independent contractors handle their taxes as business owners — you'll just give them a 1099 IRS form to report their pay. Most labor law protections also don't apply to them. So, for example, you don't need to pay for their worker's compensation or unemployment insurance. Instead, you'll specify the contractor's legal rights in the contract.

Scale your payroll management with a payroll system for your business

Classifying workers empowers you to fill roles as needed without worrying about regulatory or legal issues. However, handling payroll can be challenging. Some startups may shy away from the right balance of contractors and dedicated employees as a result.

You can overcome this obstacle by leveraging payroll management solutions. With the right financial expertise and software, you can stay compliant while ensuring you have the people you need to succeed.

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