If you were just to observe an office where an independent contractor and an employee were working side by side, you’d be hard-pushed to see any difference between them. Both would be typing at computers, going to meetings, and using the bathroom.
Even so, they’re not the same. There are both practical and legal differences between them.
In this post, we ask: Independent contractor vs. employee – what’s the difference? We then explore the pros and cons of each and some of the penalties you might face if you classify workers incorrectly.
Employee vs. Independent Contractor
Employees are defined as workers on the company’s payroll who receive regular wages and benefits in exchange for loyalty to the organization. An employee, for instance, can’t work for both Citigroup and JPMorgan at the same time. They must also adhere to company guidelines, including all of the stipulations in the employee handbook.
Contractors, on the other hand, are independent workers who get paid for completing projects. They don’t receive any perks or benefits (besides their pay), and they are not on the company payroll.
Contractors usually run their own legal business entities, such as limited liability companies. Organizations buy their services “off the shelf,” as and when they need them. If the contracting company sees fit, it can simply cancel them without having to offer any redundancy pay or advanced notice.
Contractors sign contracts with businesses hiring them. These set out what the company expects, the deliverables, and how long the work will go on for. Contracts can be short-term, lasting just a few weeks, long-term, or indefinite, depending on the underlying brand’s business model.
Businesses often hire contract workers because it’s cheaper than taking on full-time employees. For instance, when companies hire gig workers, they don’t have to pay health insurance, vacation time, 401(k) contributions, or any other benefits. They just pay the fee that the contractor asks for.
Independent Contractor vs. Employee Checklist
In this section, we explore the differences between employees and contractors.
Pay and Taxes
Companies pay employees and contractors differently. As discussed, employees are on the company payroll and typically receive either a fixed monthly salary or a figure determined by their hourly rate of pay.
Contractors, on the other hand, aren’t on businesses’ payroll. Instead, companies pay them in a similar way to how they might pay a vendor by making a bank transfer or sending them a check in the post.
There are also differences when it comes to taxes. Firms tax employees on behalf of the IRS by automatically deducting anything they owe from their paychecks. They then provide breakdowns of taxes paid (such as Social Security, Medicare, and federal income tax) on the pay stubs they hand out to employees at the end of the month.
Sole proprietors and partners, on the other hand, must pay contractor taxes independently, according to federal law. Companies they work for don’t pay or hold any taxes on their behalf. As such, gig workers are entirely responsible for paying their own taxes (though, in most cases, they hire accountants to do it for them).
Benefits are another point of departure. Employees typically receive financial and nonfinancial perks as part of their pay packets. Employers, for instance, might make contributions to their health savings accounts, health reimbursement accounts, or flexible spending accounts or offer them free gym memberships, company cars, and so on.
By contrast, contractors don’t receive anything other than their agreed-upon wage. If they want any of the above perks, they must buy them themselves.
Reasons for Hiring
Companies hire employees and contractors for different reasons. The main motivation for employing a worker is to gain their loyalty and leverage their skills daily, long-term. The reason for this is simple economics: It’s expensive for firms to continuously go to the market and hire the skills they need on a job-by-job basis, so bringing someone in-house cuts costs.
On the other hand, firms typically hire contractors when they require their niche expertise for a particular project. For instance, it’s common for contractors to work for firms for a couple of months and then leave once they obtain certain milestones.
Furthermore, contractors have less loyalty toward the companies they work for because they’re always on the lookout for the most lucrative projects.
Employees have a single employer (unless they have a side gig) and are subject to their employer’s rules. Contractors, on the other hand, work for many firms, either concurrently or sequentially throughout the year, depending on the type of work they do.
Of course, there are independent contractor pros and cons associated with this. On the plus side, they can take time off work whenever they like. However, if they do, they won’t get paid, which is a negative compared to a “standard” employee.
As you might expect, there are also significant differences in training and onboarding between independent contractors and employees. Contractors, for instance, don’t get much (if any) onboarding at all. That’s because they’re not joining the company long-term. Employees, on the other hand, may receive long on-ramps that introduce them to every aspect of the business, including the culture, hoping that they will stick around for the long haul.
Training is also different. Companies expect independent contractors to arrive with fully-fledged skills right off the bat, whereas they may view employees as more of a work in progress, offering professional development as a job perk.
Lastly, there are significant differences between the level of autonomy afforded by regular employment and self-employment contracts.
Employees must perform work according to the instructions of the employer. For contractors, it’s different. Firms assign them projects, but it’s entirely up to them whether they take them on or not. Moreover, companies tend to exert less control over where and how the project is completed. Contractors, for instance, don’t have to turn up at the office at set hours or dedicate certain times of day to particular tasks.
The IRS looks for specific factors that indicate whether someone working for you is really an employee. Therefore, it’s critical to get the distinction right. If you don’t, the IRS or workers may take legal action against you.
Here are the questions that’ll point you in the right direction:
- Where does the worker do most of their work? If workers spend most of their time in company offices, then the IRS will likely classify them as de facto employees. By contrast, if they work remotely, they’re more likely to be independent contractors.
- When does the worker work? Employees have to work set hours throughout the week, according to a contract, whereas contractors don’t. If you demand that contractors work during set periods, then you may be treating them more like employees in the eyes of the IRS.
- Is the worker doing full-time, continual work? A worker may also be an employee if they’re doing full-time, continual work for you. Remember, most contractors work for their business clients for a limited time and then move on. If they remain for many years, the IRS may interpret that as a sign that they are actually employees.
- Is the worker paid monthly? Another sign that a worker is an employee is if you pay them a set amount monthly instead of on a “per project” basis. The IRS may view such payments as being suspiciously similar to a regular salary.
- Does the company pay for travel? Companies will usually pay for employee travel costs because they can deduct them from their expenses. Independent contractors, on the other hand, are usually required to pay for their own transport. If companies pay for contractor transport, the IRS might consider this evidence they are actually de facto employees.
In summary, knowing the right classification for your workers is essential. If you misclassify, you may have to pay both back taxes and fines to the IRS. The size of the bill will correspond to the number of Form W-2s that you failed to file because you didn’t correctly classify an independent contractor as an employee.
Furthermore, if the IRS believes you deliberately and persistently misclassified workers, you may face criminal penalties. These could include fines, jail time, and damages litigation by workers.
Employee Pros and Cons
Let’s take a look at some of the positives and negatives associated with hiring an employee.
Pros of Hiring Employees
- Part of a team and often want to go the extra mile to advance their careers
- A sense of loyalty and duty toward the firm
- Able to perform routine tasks over long periods
- Can take on extra work when the need arises
Cons of Hiring Employees
- Training and professional development can be expensive
- Salaries must be paid like clockwork, regardless of the business’s cash flow position
- Perks and other employee-related expenses can add to the cost of hiring
- Recruitment and interview processes can take a long time
Pros and Cons of Independent Contractors
Now, let’s take a look at some of the pros and cons of independent contractors:
Pros of Hiring Independent Contractors
- Save money overall because you’re not committed to paying any benefits or salary
- Easily hire the right person for the task without the need for additional training
- Gain greater flexibility; if a contractor isn’t a good match, there’s no need to hire them again
- The contractor takes care of all the permits and licenses they need; it’s not the business owner’s responsibility
Cons of Hiring Independent Contractors
- Some loss of control over how they perform tasks
- Difficulty closely monitoring their work and assessing the quality of their contributions
- Lack of company loyalty
- Independent contractors own the copyrights to their work unless you write up an agreement stating otherwise
- Hired short-term and may require administratively costly re-hiring in the future
Essentially, the difference between an independent contractor and an employee comes down to the relationship of the worker to the firm hiring them. If they receive regular wages, follow instructions of senior managers, and work at the employer’s place of business, then they are probably an employee. However, if they work relatively independently, don’t receive benefits from the employer, and operate remotely, then they are more likely to be a contractor.
Correctly classifying workers is essential. Failing to do so properly can result in having to pay hefty back taxes and fines to the IRS. Furthermore, wrongly classified employees may litigate against you.