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Independent Contractor vs Employee: The Key Differences

Do you know the difference between an employee and an independent contractor?

That’s what regulators in California asked Uber in 2015 when the ride-sharing giant was sued for “misclassifying” a driver as an independent contractor.

They eventually ruled that the driver was an employee. Which led to a much larger lawsuit in 2016, when Uber paid misclassified drivers in California and Massachusetts more than $100 million.

In this guide we’ll show you how to distinguish between employees and independent contractors—and what can happen if you don’t.

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Classifying workers

Classifying a worker as an employee or an independent contractor has a significant effect on the cost of employing that individual. For this reason, the IRS and Department of Labor pay close attention to worker classification issues to ensure that employers are making the right determinations.

A business may pay an independent contractor and an employee for the same or similar work, but there are important legal differences between the two. For the employee, the company withholds income tax, Social Security, and Medicare from wages paid. For the independent contractor, the company does not withhold taxes. Employment and labor laws also do not apply to independent contractors.

To determine whether a person is an employee or an independent contractor, the company weighs factors to identify the degree of control it has in the relationship with the person.

• Does the company control or have the right to control what the worker does and how the worker does the job?

• Does the company control the business aspects of the worker’s job? These include arrangements like how the worker is paid, whether expenses are reimbursed, and who provides tools and supplies.

• Is there a written contract or employee benefits such as a pension plan, insurance, or vacation pay?

• Will the relationship continue and is the work a key aspect of the business?

The Internal Revenue Service uses a right-to-control test to assess a business’ tax liability. Visit the IRS website for more information.

Each state also has tests to determine a person’s status under workers’ compensation and unemployment insurance laws.

How Does the IRS Determine 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.

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.

To help distinguish between employees and independent contractors, the IRS has set up three general criteria:

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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.

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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.

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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.

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The IRS Always Assumes Workers Are Employees
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 (PDF) to request a determination from the IRS. The IRS doesn’t issue determinations on hypothetical situations. it says that the Form SS-8  should be submitted “only in order to resolve federal tax matters.”

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The IRS says:

Neither the Form SS-8 determination process nor the review of any records in connection with the determination constitutes an examination (audit) of any federal tax return.

See this IRS article on “Independent Contractors vs. Employees” for more details on the subject of independent contractors or employees.

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The key difference
The key difference between an independent contractor vs. an employee comes down to taxes. An employer is responsible for withholding taxes, including income tax, social security tax, and Medicare tax from an employee’s paycheck. An employer is not responsible for withholding taxes from an independent contractor. Instead an independent contractor is responsible for paying both employer and employee taxes to tax authorities.

Do you know difference between an independent contractor vs. an employee? As you grow your business, understanding the distinction between these two terms will be critical.

Hiring an independent contract vs. an employee 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 independent contractor vs. employee? And why is it important to categorize the people who work for you correctly?
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Let’s see the main differences between the two…

1. Business ownership
Independent professionals may be sole proprietors, or have an incorporated business. They have built these businesses around specialized services they provide—it’s not uncommon for independents to have a business name and perform work for multiple clients. Think of your relationship with an independent contractor as a business-to-business relationship. It can be easy to fall into the trap of treating them like an employee, but doing so can put you at risk for misclassification.

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2. Industry expertise
While employees typically receive some sort of training surrounding their job duties, independent contractors bring specialized expertise to a project or task. As a client, you’re not responsible for providing them with training—pretty nice, right? Independent talent can be a great way to fill business needs.

While independents come from and work in virtually every sector of the economy, most demonstrate a high level of specialization in their industry. In fact, the majority of independents say they get work assignments because they offer a specialized skill that requires certification, special training, or education.

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3. Open Marketing
Remember, because independent contractors are running their own business, they need to sell and market their services. Just because they have a long-term contract with you doesn’t mean they aren’t allowed to take on additional work for other clients as well.

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4. Time contraints
Unlike traditional employees whose jobs may encompass a wide variety of duties and tasks, independent contractors are only responsible for performing the services outlined in a contract or Scope of Work (SOW). A clear SOW provides the foundation for a good working relationship, outlining the expectations of both parties. It should include details about the work to be done, a time frame, a process for managing changes, and payment terms.

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5. Payment
Rather than working for a specific salary, independent contractors submit invoices for their work. Pay and payment terms should be discussed during initial contract negotiations. Independent contractors may have a standard billing rate for their services, or their rate may vary depending on the type of work you are looking for. Be sure to discuss how and when you’d like the contractor to invoice you for work completed, as well as how and when you will pay them after receiving an invoice.

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6. Scheduling
Because independent contractors are their own business entity, a client cannot determine their work hours. They alone are responsible for fulfilling the work agreement—when they work and the hours they keep is completely up to them.

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7. Oversight
While employees typically receive instructional oversight from a manager, a client cannot determine how an independent contractor works. For example, independents typically provide any needed tools or equipment. If a project requires specialized equipment that is only available on site, this should be stipulated in a contract. If an independent contractor does need to work on site, ensure relevant company managers and employees are aware of processes and protocols so they do not treat the contractor like an employee.

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8. Taxes
When it comes to taxes, as a client you will typically complete Form W-9 to request the correct name and Taxpayer Identification Number (TIN) of the independent contractor, and Form 1099-MISC, to report payments made. As a client, you don’t have to worry about withholding taxes for contractors you engage. Independents should be aware of their own tax responsibilities. They pay what’s known as self-employment (SE) tax, which includes both the employer and employee halves of Social Security and Medicare (FICA).

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9. Benefits
There are many financial benefits to engaging independent contractors, including not having to provide traditional benefits such as health insurance, stock options, or retirement plans.

Independents also do not receive the same legal protections—unemployment, anti-discrimination, and Workers’ Compensation—as employees. Nevertheless, it is good practice to ensure independent contractors have basic insurance requirements built into their contract to protect against any legal issues.

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10. Delegation
Independents may have their own employees, subcontractors, or partner consultants who help them to complete work tasks. During initial discussions, ask the independent contractor you are engaging if they utilize additional work resources. If they do, this should be outlined in your contract along with any necessary details. Remember, if independents do engage extra resources, they alone are responsible for the tax responsibilities, and filing and reporting requirements for these workers.

It's a Social Media and digital marketing consultant and owner and founder of LFStudio.com. He is also author and entrepreneur. He helps small businesses to grow, get clients and generate income.

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