Employee vs. Contractor: Understanding the Difference

Gabrielle Sinacola | Aug 8, 2023

Employee vs. Contractor: Understanding the Difference

Contractor work arrangements are popular. According to the US Government Accountability Office, about one-third of all businesses and almost 90% of Fortune 500 companies use independent contractors in some capacity. Hiring contractors can be a particularly attractive option for early-stage businesses because it allows them to leverage specialized skill sets while building their internal teams.

But contractors are very different from employees, and the two mustn’t be conflated—or hefty penalties can apply. While contractors are self-employed individuals or even incorporated business entities, employees are typically economically dependent on their employers and so are entitled to certain rights and protections under the law. For this reason, misclassifying an employee as an independent contractor is a compliance violation: It denies a worker rights to which they are otherwise entitled.

To make classification decisions, business owners need to know how different jurisdictions and government agencies evaluate worker status.

What is a contractor?

A contractor (or independent contractor) is a self-employed individual who performs work for another entity under a written or verbal agreement.

Although worker classification systems vary among different federal agencies and states, independent contractors frequently exhibit the following characteristics:

  • They control when they work. Unless their work requires a presence on a specific job site, they may also control where they work.
  • They use their own tools, not tools provided by the hiring entity.
  • They can work for multiple entities simultaneously.
  • They are hired for a previously acquired skillset, not trained by the hiring entity.

Independent contractors file their own income taxes. Because they are not employees, they’re also subject to a self-employment tax, which consists of social security and medicare taxes. The 2023 self-employment tax rate is 15.3%.

What is an employee?

An employee is a worker who performs work for an entity and is not otherwise classified as an independent contractor.

As with independent contractors, definitions vary by agency and jurisdiction. Common characteristics of an employee include the following:

  • They work at a time and place determined by the employer.
  • Their work methods may be controlled by their employer.
  • They often work for only one company.
  • They use tools provided by their employers.
  • They may receive training.
  • They perform work that is an integral part of a business.
  • They are often reimbursed for necessary business expenses.

If a worker is an employee, their pay is typically subject to social security tax, medicare tax, and state and federal income tax withholding. Employees may also be entitled to other benefits and protections, such as workers’ compensation and unemployment insurance coverage.

Employee vs. contractor: Understanding the difference

Determining whether a worker is an employee or an independent contractor is important. Businesses that misclassify an employee as an independent contractor can face the following penalties:

  • A $50 fine for each Form W-2 the employer failed to file
  • A penalty of up to 3% of the wages, plus up to 40% of the FICA taxes that were not withheld from the employee
  • Up to 100% of the matching FICA taxes the employer should have paid
  • For intentional employee misclassification, criminal penalties of up to $10,000 per worker and one year in prison per misclassified worker may apply.

Correctly classifying workers can also be tricky. Different government agencies and jurisdictions use different systems, and none of them establish criteria that conclusively determine worker status. Instead, they encourage businesses to make a determination based on the factors in each specific case.

Here’s an overview of federal and state worker classification guidance.

Internal Revenue Service guidance

The Internal Revenue Service (IRS) worker classification system is sometimes referred to as the “common-law test.” According to the IRS, a worker is an employee if the hiring entity has the right to control how work will be performed, regardless of whether or not the entity exercises this right.

The Common-Law test considers the degree of control and degree of independence in three categories: behavioral, financial, and type of relationship. Here’s an overview:

  • Behavioral control. A company has behavioral control if it has the right to control what the worker does and how the worker does their job. The IRS considers types of instructions given, degree of instruction, training provided, and whether or not evaluation systems consider how the work is performed.
  • Financial control. A company has financial control factors if it has the right to control the economic aspects of a worker’s job. Factors include the worker’s investment in equipment and tools, how the worker is paid, if the worker is available to perform other work in the given market, whether worker expenses are reimbursed, who provides tools or supplies, and the worker’s opportunity for profit or loss.
  • Type of Relationship. The type of relationship category provides data about how a company and worker view their arrangement. The IRS considers written contracts, the presence of employee-type benefits, the permanency of the relationship, and the relationship between the services provided and the hiring entity’s core business activities.

In all cases, factors that point toward a greater degree of control suggest that the worker is an employee, and those that point toward a greater degree of independence suggest that the worker is an independent contractor. The IRS does not consider job title or whether the individual is a part-time or full-time employee or contractor in status determinations.

The IRS advises a business to consider all factors, noting that in many cases, some factors will indicate that a worker is an independent contractor and others will indicate that the worker is an employee. Official guidance reads as follows:

There is no “magic” or set number of factors that “makes” the worker an employee or an independent contractor and no one factor stands alone in making this determination. Also, factors which are relevant in one situation may not be relevant in another. The keys are to look at the entire relationship and consider the extent of the right to direct and control the worker.

The IRS also provides help determining the proper classification status. Either a business or a worker can file Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. The IRS will review the facts and make an official determination of status.

Department of Labor guidance

The US Department of Labor (DOL) defines an employee as “any individual employed by an employer,” where the definition of “employ” includes “to suffer or permit to work.” This definition determines whether or not a relationship is subject to the provisions of the Fair Labor Standards Act (FLSA), including federal wage and hour laws and other employee protections.

Unlike the IRS, the DOL determines worker status based on whether or not a worker is economically dependent on a hiring entity. According to agency guidance, an independent contractor is generally engaged in a business of their own and is economically independent from a hiring entity, and an employee is economically dependent on the entity they serve.

Like the IRS, the DOL maintains that no single rule conclusively determines worker status. Instead, it cites the following factors considered by the US Supreme Court to be relevant to status determination:

  • 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 worker’s investment in facilities and equipment
  • The nature and degree of control by the hiring entity
  • The worker’s opportunities for profit and loss
  • The level of skill required to perform the work
  • The worker’s degree of independent business organization and operation
  • The amount of initiative, judgment, and foresight required to compete for this type of work on the open market

Factors that point toward economic independence suggest that a worker is an independent contractor, and factors that point toward economic dependence suggest that a worker is an employee. The DOL also disregards the following factors, which have been determined by the Court to be immaterial to worker status:

  • Where work is performed
  • The absence of a formal employment agreement
  • Whether a worker is licensed by a state or local government
  • Time or mode of pay

Generally speaking, the DOL’s definition of employee is broader than the one used by the IRS, which means that a worker can be considered an independent contractor for tax purposes and an employee under the provisions of the FLSA.

National Labor Relations Board guidance

The National Labor Relations Board (NLRB) worker classification guidance has changed multiple times in the last decade. Current guidance has been in place since 2019 and relies on a 10-factor system known as the “common-law agency test.” The common-law agency test encourages businesses to consider the following factors, acknowledging that no one factor is decisive:

  • The extent of control the hiring entity exercises over the details of the work
  • Whether or not the worker is engaged in a distinct occupation or business
  • The kind of occupation, specifically whether the type of work is usually done under the direction of an employer or without supervision
  • The skill required in the particular occupation
  • Whether the hiring entity or the worker supplies the instruments, tools, and the place of work
  • The length of time for which the worker is contracted
  • Whether the worker is paid for time or by the job
  • Whether or not the work is part of the regular business of the hiring entity
  • How the parties view the relationship
  • Whether or not the hiring entity is a business

As of May 2023, the NLRB is considering amendments to the common-law agency test, including a possible return to the guidelines used after the 2014 Board Decision FedEx Home Delivery. This system made it significantly harder for businesses to classify certain workers as independent contractors by minimizing the significance of “entrepreneurial opportunity” in determining whether or not a worker is engaged in a distinct occupation or business.

State level guidance

Different states also use different criteria to determine worker status. Many apply the IRS’s common-law test or a version of the DOL test referred to as “the ABC test,” which assumes that a worker is an employee unless the following three factors are met:

  • Absence of control. The worker is free from control by the hiring entity.
  • Business of the worker. The worker’s services are outside the scope of the hiring entity’s usual business activities.
  • Customarily engaged. The worker has a business identity on the open market and is customarily engaged in the same type of work that they are contracted to perform.

Because the ABC test places stricter parameters around independent contractor classification than the common-law test does, two workers performing the same job might be differently classified in different states. Individual applications of these tests can also vary. For specific guidance, consult the relevant state agency, such as the state’s Department of Labor, Department of Revenue, or Department of Administrative Services.

Managing state and local requirements for your workforce can be complicated and expensive. Mosey’s compliance platform streamlines employment and tax compliance. We provide the information and tools to identify, automate, and manage ongoing compliance when it comes to your workforce. Receive alerts when requirements change or changes to your business and employment structure qualify you for new requirements.

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