There are important distinctions between an employee and an independent contractor. Misclassifying an employee as a contractor can result in significant tax penalties, you don’t want to be on the wrong side of the IRS’s definition. So, here's what you should know:
As businesses grow, staffing needs increase. Should an organization hire an employee or independent contractor?
An independent contractor may feel like a part of the team. And their independent status doesn’t mean they can’t — or shouldn’t — be a major contributor to the company’s goals and culture. But there are important distinctions between an employee and an independent contractor. Misclassifying an employee as a contractor can result in significant tax penalties, you don’t want to be on the wrong side of the IRS’s definition.
This article examines the differences between an employee and an independent contractor. We start with a basic definition, before moving into the common law test often used to make a determination as well as more recent trends impacting the differences.
What is the main difference between an employee and an independent contractor?
The simplest definition is that an employer needs to withhold payroll taxes such as income taxes, Medicare and Social Security for an employee, but not for an independent contractor. So while an employee and a contractor might be paid the same, the responsibility for withholding taxes falls to the contractor.
That also means there are different tax forms for independent contractors you’ll need to gather. At a minimum, this includes a W-9 and a Form 1099-MISC if you pay the contractor $600 or more in a year.
Furthermore, contractors are typically not covered by labor laws, they operate independently of the hiring entity, and usually don’t receive health benefits.
While these definitions are helpful, they do not necessarily demonstrate how to determine which category your employees belong to. For this, we have to look at something called the Common Law Test.
What is the Common Law Test?
The common law test helps employers categorize their workers as independent contractors or employees. According to the IRS, one of the most important points is whether the employer is only able to control the results of the work or if they are allowed to have input on how the work is performed as well. The key factors of the common law test look at the type of relationship between the parties, who determines the behavior, and who has financial control.
In general, if the employer has the right to control what work will be done (even if they do not exercise that right) and how that work will be done, then that individual should be classified as an employee under the common law test. But if an individual determines how best to complete a job and is only told what needs to be accomplished, he or she would likely be classified as an independent contractor.
It’s worth taking a look at an example of how this would be applied. So, for instance, let’s consider how an employee vs. an independent contractor would replace a window:
- Employee Example: The individual is provided ongoing training on how to replace types of windows, and he or she receives detailed instructions about when, where, and how to work. Employees are provided the necessary tools, reimbursed for any expenses incurred, and are paid by the hour, week, or month. Employees also receive benefits and maintain an ongoing relationship with the employer.
- Independent Contractor Example: The individual is told to replace a window, but how the contractor approaches the job is up to him or her. Any payment received for the work performed is all-inclusive, meaning contractors won’t be reimbursed for their expenses. Also, contractors maintain their own tools and equipment, and they typically complete similar services for other clients daily.
If you want a deeper dive, check out this course from the Social Security Administration on how to apply the common law test.
Hiring contractors can result in lower employer taxes, but it’s important to properly classify the worker, or significant tax penalties can be imposed. The common law test looks at who controls the behavior, who has financial control, and the relationship of the worker with the business in determining the employee classification.
Are there exceptions to the common law test?
The short answer is “yes.” There are three noteworthy exceptions we’ll explore here.
Passing the reasonable basis test
Section 530 of the Revenue Act of 1978 provides that an employer may treat a worker as an independent contractor exempt from federal payroll tax laws if they have a reasonable basis for doing so. A reasonable basis would include one or more of the following:
- Court decisions, published IRS rulings, IRS technical advice sent to the employer or a private letter ruling from the IRS indicating the worker is not an employee
- A past IRS audit of the employer that did not result in a finding of taxes owed or a penalty attributable to the employer’s treatment of the worker
- Longstanding, recognized practice in a significant segment of the employer’s industry or treating workers in similar situations as independent contractors.
In addition to the above, the employer must have treated all the workers in question and similar workers as independent contractors. The employer also must have issued a 1099-MISC for each of the workers (unless a worker earned less than $600).
The worker is classified as a statutory employee
If an independent contractor is passed through the common law test, they can still be classified as an employee by statute if they fit any of the four following conditions described by the IRS:
- A driver who distributes beverages other than milk, meat, vegetables, fruit or bakery products; or a driver who picks up and drops off laundry or dry cleaning if the driver is an agent for the company or works on commission.
- A full-time life insurance sales agent selling either or both life insurance or annuity contracts primarily for one life insurance company.
- A contractor who works from home on materials or goods that the business supplies and must be returned to the business, or a person the business specifies, if the business also provides specifications for the work to be done.
- A full-time traveling or city salesperson who works on the business’s behalf and turns in orders to the business from wholesalers, retailers, contractors, or operators of hotels, restaurants, or other similar establishments. The goods sold must be merchandise for resale or supplies for use in the buyer’s business operation. The work performed for the business must be the salesperson’s principal business activity.
These are direct sellers, licensed real estate agents, and certain companion sitters who are considered contractors rather than employees if they fit the following two conditions:
- Substantially all payments for their services as direct sellers or real estate agents are directly related to sales or other output, rather than to the number of hours worked, and
- Their services are performed under a written contract providing that they will not be treated as employees for Federal tax purposes.
What about the ABC contractor test?
At this point you might be asking, “Didn’t I hear about a new test for determining contractors?”
If you live in California (or New Jersey, or Massachusetts) you might have heard about the ABC test for determining contractors. The California Supreme Court determined that a worker for a business will be considered an employee unless they fit all three of the following criteria:
- A) That the worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact;
- B) That the worker performs work that is outside the usual course of the hiring entity’s business; and
- C) That the worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed.
Your choice to hire an employee or an independent contractor should be based on your business needs, talent, and culture, among a variety of other factors. But whatever you decide, make sure you know the difference and provide clarity to your team about their status.
While this shift is only happening in California (with similar rules in Massachusetts and New Jersey), given the size of the California economy, the number of contractors in state and the rise of the gig economy, it could have larger repercussions over time. Subscribe to our blog to stay updated on these types of changes!