What is the difference between an independent contractor and an employee?

A great question – What is the difference between an independent contractor and an employee? In the last few decades, the numbers of independent contractors have mushroomed.  The reason in many cases is to force workers to pay for an “opportunity to work” rather than paying wages and overtime, like a worker who purchases a “contract” to clean a building, or a taxi driver who rents a cab for a twelve-hour shift.  There is very little difference in the work done between these independent contractors and full-time employees doing the same job. But the independent contractor (IC) label keeps workers from getting the protection of the labor laws at the Federal and State level as well as denying them the right to organize into a labor union.

Advantages of hiring IC over employees.

  • There is reduced overhead costs in using independent contracts.  
  • Reduced payroll taxes and the expenses of paying and accounting for such payroll.  
  • No benefits for independent contacts means no health insurance, no vacation, no jury duty, no time off with pay.
  • The independent contractor works when the employer wants him to.  There is full flexibility about when they work with no overtime pay and no pay for down times.
  • You can get very experienced and well-trained contractors.

Disadvantages of hiring IC over employees.   

  • No or limited employee loyalty. Loyal and dedicated employees tend to be very productive.  
  • Getting ICs to do extra work. Since they are technically self-employed, they will not be as willing to lend a hand in running your business as an employee will.
  • ICs may set their own schedules because of other contracts they are fulfilling at the same time.

Disadvantages to hiring employees.

  • You now have a person who is depending on you to provide for them and their family.  You may be in an employment-at-will situation but employment generally means permanency or long-term employment.
  • If you lay off an employee, you’ll have unemployment costs which can be very expensive.  
  • You have extra overhead, facilities, taxes, benefits and the like.  
  • The employee that stays with you is going to expect supervision, growth, training and a maybe future path to a higher position.

As there are downsides to employees, there are downsides to independent contractors besides scheduling, as mentioned above.  Independent contractors are not, as we will discuss later, subject to your control. Their charges are subject to market variation and demand.  You may pay them $25.00 an hour this month and with changes in the market and demands on their time next month you may find their rate to be double.  

If you have misclassified a new hire as independent contractors and the IRS says they are really employees the taxes, penalties, and interest due can be devastating.  Remember that the IRS and the Department of Labor would prefer there be no independent contractors.

How does the IRS decide who is an employee and who is an IC?

In 1987, the IRS created a list of 20 factors they consider relevant after examining the case law.

The amount of weight given to each of the twenty factors depends on the job and the actual situation that the worker operates in.  The twenty items listed in the IRS Revenue Ruling 87- 41 include the following:

  1. Instructions: If the employer has the right to require the worker to comply with the employer’s instructions.
  2. Training: If the worker can be required to attend training as to how the work is done.
  3. Integration:  Are the services performed by the work integrated into the normal operations of the business.
  4. Personal Service:  Does the employer require that the worker perform the services or can the worker at their own behest substitute another person.
  5. Hiring, supervising, and paying:  If the employer hires, pays, and supervises assistants for the worker rather than the worker hiring, paying and supervising his or her own assistants. This is an indication of control.
  6. Continuing relationship:  That the employer and the worker maintain an ongoing and continuous relationship.
  7. Set hours of work: The worker has established regular hours for work set by the employer.
  8. Full time required:  The worker should work full time for the employer rather than be free to work for whomever they want to and whenever they want to.
  9. Work on the employer’s premises: The services performed by the worker are performed in facilities controlled by the employer.
  10. Sequence test: The worker performs tasks in the order that the employer specifics.
  11. Reporting: The worker must submit reports either verbally or in writing on a regular basis.
  12. Payment:  The work is paid by a time unit (Hour/day/week/etc.) as opposed to being paid by the job.
  13. Expenses:  If the employer pays the expenses for the worker it leans toward an employment status.
  14. Tools: Normally if the worker’s tools are provided this would indicate that the worker is an employee.
  15. Investment: If the worker has made a significant investment in the facilities where the work is performed it indicates that the worker may be an independent contractor.
  16. Profit or loss: A worker who is an employee does not normally make a profit or a loss in addition to his normal pay.
  17. One Employer: Normally a worker who performs the same service for multiple employers at the same time is indicative of an independent contractor.
  18. Generally Available:  If the worker makes his services available to the general public it is indicative of an independent contractor.
  19. Discharge: The ability of an employer to fire a worker leans toward the worker being an employee.
  20. Termination: A worker who can quit at any time indicates that the worker is an employee.

Employment conditions that play a role in new hire classification.

The IRS has identified three types of conditions could be used in determining the status of a worker as an independent contractor or an employee:

(1) Behavioral control;

(2) Financial control; and

(3) Relationship of the parties.

The IRS makes the point that in addition to the twenty common law tests there other factors that may be relevant to the status and that the weight allocated to each factor may vary based on the situation.  

In general, the following is true.  Individuals who offer the services they perform in the course of their profession to the general public are normally independent contractors.

Courts realize that highly skilled or highly educated workers don’t require the minute by minute supervision so day to day control over a worker in not necessarily helpful in determining status.  The courts are tending to focus on the worker’s ability to realize the profit or loss from their services particularly as shown by who pays expenses and who finances the business.