Independent Contractor vs Employee: What’s the Difference?

How you classify your workers matters. In fact, companies that mis-classify contractors face steep fines and legal penalties. If you’re wondering what the differences are between an independent contractor (IC) and an employee, you’re in the right place. Let’s look at a quick definition of both types of worker and what each looks like in practice.

What is the definition of an employee?

According to the IRS, an employee is anyone who works for a business that can define “what will be done, and how it will be done.”
For example, a business could tell an employee where they need to work or how much they will be paid for the work.

What is the definition of an independent contractor?

The IRS classifies independent contractors as workers who have more control over how they work. Employers can only define “the result” of the work and elements such as the pay, the location, or the working hours are up to the contractor.

This is a perfect arrangement for employers seeking a niche skill quickly or augment an in-house team with more manpower for a specific project.
Beyond being able to decide where and how employees work, there are other key distinctions between ICs and employees and knowing these will protect businesses from misclassification and allow them to stay agile by hiring each worker as needed.

Differences between independent contractors and employees

One of the main differences between employees and ICs is that employers do not need to contribute to contractors’ taxes for Medicare and Social Security. Independent contractors also have total control over their workday schedules, but may not have access to employer onboarding or training resources.

Conversely, employees are usually paid a fixed salary and are eligible for benefits such as paid time off, taxes, and extras such as expenses or training. Employers will also need to pay Social Security taxes, Medicare and Unemployment, health insurance, 401k matching, disability insurance and worker’s compensation.

Independent contractors typically cost businesses less money, but costs are far less predictable, as contractors can create their own rates and often charge by the hour. A freelancer or an independent contractor is responsible for filing their own taxes—all employers need to do operationally is fill out Form W-9.
Knowing these differences is a great start to correctly classify each worker, but there are other signs your contractor is really an employee or vice versa.

How to distinguish between contractors and employees

In some cases it’s more clear cut whether the worker is a contractor or a full-time employee. From supplies to payment processes, employers can use the following to distinguish between the two types of workers:

Supplies

Independent contractors are responsible for providing their own supplies and any necessary training to help with the project. This applies to anything from computers to software down to pens and paper.

When hiring employees, employers must provide workers with any necessary resources to get the job done.

Behavioural control

Working as a contractor vs. an employee means the former has complete autonomy when it comes to location and working hours as long as they deliver a result that matches the business’s expectations. They can work from one location one day and another the next, work three hours one day a week, and nine another.
They can use any strategy to get the work done; for example, outsourcing certain project elements to other professionals or working with specific tools.

Employees usually work specific hours and in a location determined by their employer. Employment contracts typically spell out a standard working week that consists of eight to nine hours per day, five days a week at the company’s main office.
Employees can access the company’s tools and resources to perform their job, but may not have the freedom to choose how they’ll carry out the work.
Benefits

Contractors are responsible for paying 100% of Social Security and Medicare. And as contractors aren’t employees, employers aren’t required to provide benefits or job performance-related training.

On the other hand, employers provide employees with benefits such as paid time off, contributions towards Social Security, Medicare, health insurance, and so on, and additional expenses such as professional training.

Financial

Unlike employees, there aren’t standard contractor payment terms. Contractors can invoice businesses per project or for a number of hours completed. Payment terms are based on an agreement between the contractor and business with contractors setting their own rates.

Employees typically work under a standard contract that outlines what their salary will be each month or bi-weekly for work that continues indefinitely. Overall, there is a lot more operational heavy lifting when it comes to hiring an employee vs. a contractor.
It’s helpful to know the differences between employees and contractors, but to decide which is right for business, companies can also consider options such as statutory employees, or non-statutory employees.

Different types of employees

Businesses can work with a variety of workers depending on their needs. Here’s a rundown of employee types:

• Independent or freelance contractors- these are professionals hired directly by the client (the business) for a specific project or on a freelance basis.
• Employee- workers are hired by the business indefinitely and must adhere to certain guidelines regarding where, how, and when the work gets done.
• Statutory employee- these workers are treated as independent contractors for tax purposes. Employers and statutory employees both pay into Medicare and Social Security taxes.
• Non-statutory employee- Professionals work under a written contract and aren’t treated as an employee for tax purposes. Employers do not need to withhold FIT and FICA from their worker’s earnings.

Classifying a worker’s status isn’t always easy. That’s where the SS-8 comes in.

What is Form SS-8 and what is it for?

Businesses and workers can file Form SS-8 to request the IRS determine the status of a worker for federal employment taxes and income tax withholding purposes.

This determination classifies the worker as either an employee or an independent contractor. Businesses should note that once a decision is made, it’s binding.
To further illustrate the differences between ICs and employees, take a look at the table below:

For any company, compliance must be a high priority. As the penalties for misclassification run steep, it’s in the business’s best interest to correctly classify contractors, especially for brands with local entities in foreign countries.

The consequences of misclassification

The consequences of misclassifying contractors range from monetary penalties to jail time, depending on local labor laws and whether the company intentionally broke the law or not. In the U.S. (depending on whether the case is intentional or not), companies can face:

• Tax violation fines
• Payment penalties of up to $1,000 per misclassified worker
• Employee benefits insurance repayments
• Class action lawsuits
• Wage claim audits
• Punitive damages
• Jail time

If employers realize they have misclassified an independent contractor, they’ll need to amend the worker’s status.

How to switch from contractor to an employee

At some point, you might need to convert an independent contractor to an employee. Companies can use the following steps to convert contractors to an employee:

1. Verify worker classification

The first step in switching classifications is to make sure it’s in the business’s best interest. If a company frequently changes classification, the IRS may respond with an audit.
To determine if a worker is a contractor or employee, employers can use the IRS three-prong test, or file Form SS-8 with the IRS. Employers will also need to use Form W-2 to report the employee’s wages, as opposed to 1099-MISC, which is used for contractors.

2. Notify the worker in writing

When companies decide to convert a contractor to an employee, they must notify the worker in writing, documenting the notification date.

3. Collect employee information

Employers will also need to collect the employee’s information. The worker will need to fill out Form W-4 and Form 1-9 to verify their eligibility to work in the U.S. Businesses will also benefit from including information about the employee’s pay, such as the rate, whether they are salary or hourly, exempt or non-exempt, and the pay frequency.

4. Adjust payroll

Employers will need to add their new employee to payroll to pay them the right amount and on time. Other information to include is their pay rate and pay frequency.

5. Provide employee benefits

Converted employees are entitled to any benefits other employees receive, such as paid time off, Medicare, Social Security, and so on.

6. Distribute Form W-2

All employees must receive Form W-2 after the end of each year. Form W-2 reports their wages during the year and how much tax employers withheld from their wages. Companies must send the W-2 to the employee by January 31st and also send the form to the Social Security Administration.

Companies must also be careful when taking on independent contractors in order to remain compliant.

How to hire an independent contractor

There are a few key concepts businesses can use to hire an independent contractor. Here are the steps:

1. Check the worker’s classification – Before hiring and onboarding the contractor, employers need to verify the worker’s classification to avoid instances of misclassification and other trouble down the road.
2. Review the contractor’s experience- One of the benefits of hiring contractors is being able to utilize their expertise right away without needing to train them. That’s why companies may want to review the contractor’s experience and credentials to ascertain how they can contribute to business goals and objectives.
3. Write a contract- A contract can help companies classify contractors and establish guidelines for the projects or assignments. Businesses may want to include aspects such as the payment cycle, contractor payment rates, and non-disclosure agreements.
4. Have the contractor fill out necessary forms- Along with signing the contract, contractors will also need to complete the W-9 and the 1099-MISC if they earn more than $600 during the year.
5. Integrate the contractor into the company culture- It’s often helpful to hold an introductory meeting to welcome contractors to the company, reiterate goals, and explain processes. Companies may also want to introduce contractors to other employees who can help with certain questions or concerns about their project. This will help the contractor feel more invested in the company’s objectives and growth and allow them to work more efficiently.

Once you’ve hired an independent contractor, it’s time to include them in your payment cycles.

How to pay an independent contractor

Companies can use a variety of methods to pay contractors, though many choose a payroll software to run payroll, especially if working with contractors from several countries. Companies can also pay workers through:

• Bank account transfers (SWIFT or wire transfers)
• Credit card payments
• Freelance platforms
• Cryptocurrency payments
• Dedicated money transfer providers

Understanding the differences between ICs and employees comes to accessing the right information.

Helpful resources for employees vs independent contractors

• Internal Revenue Service, “Understanding the Employee vs Contractor Designation” MIT, “Estimating the Cost of an Employee”
• Nolo: “Documentation Required to Work in the United States”
• US Dept of Labor: “Fact Sheet: What is an Employee Relationship under the Fair Labor Standards Act (FLSA)?”
• JD Supra: “A Decade of Examples of Contractor Misclassification”
• If you’re still not sure which designation your worker needs, you can ask the IRS to make the decision for you, by filling out this form.

The Papaya Advantage

Papaya Global utilizes a specialized center of excellence model, with vast expertise and support on different types of employment, and how each will impact your business growth. Uniquely, we also offer a full range of global workforce solutions, including technology that manages everything from payroll employees and contractors, to Employer of Record relationships worldwide, so that you can get a single view of your whole workforce, no matter who that includes.
For more information, reach out here.