Employees vs. Independent Contractors

Correctly classifying employees vs. independent contractors is key to avoiding trouble with the IRS. Below, we’ve covered the common details regarding employees and independent contractors every employer needs to know.

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What Are Employees vs. Independent Contractors?

There are many potential differences between employees and independent contractors. But the primary difference (and the difference that matters to the IRS) has to do with how much control a worker has over the work they do.

Control, in this case, can be thought of alongside independence. How free is the worker to complete the assigned work as they wish? Who is in charge of the details—the business or the worker?

As a general rule, the more an employer controls a worker, the more likely the worker is an employee. But this is not necessarily true in every situation, and there are many other factors that can help determine a worker’s employment status.

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The Importance of Correctly Identifying Workers

The main reason it’s important to correctly identify a worker as an employee or independent contractor is for tax purposes.

As an employer, you are responsible for paying a portion of your employees’ payroll taxes. Employers are not responsible for paying any of an independent contractor’s income-related taxes—independent contractors must pay their own.

If a worker is treated as an independent contractor when they should have been treated as an employee, the employer could be held liable for the employment taxes that went unpaid.

How do I classify workers correctly?

Businesses need to weigh numerous factors when determining whether a worker is an employee or independent contractor. There is no magic or set number of factors that classifies the worker one way or the other, and no one factor stands alone in making this determination. Keep in mind, too, that relevant factors may vary by situation.

The keys are to look at the entire relationship, consider the degree or extent of the employer’s right to direct and control, and to document each of the factors used in coming up with the determination—issues we’ll cover in detail in the sections below.

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Determining Worker Control

The amount of control a worker has over their work helps the IRS figure out if they’re an employee or independent contractor.

The IRS uses three general factors to determine worker control: Behavioral Control, Financial Control, and Type of Relationship. When you’re figuring out a worker’s status, you can use these factors, too.

Behavioral Control

Behavioral control determines if an employer has a right to direct how a worker does their assigned work. The existence of behavioral controls can indicate that the worker is an employee.

The IRS further defines behavioral control via four categories: type of instruction, degree of instruction, evaluation systems, and training.

  • Type of Instruction
    Type of instruction identifies how an employer tells a worker or service provider to work. In most cases, only employees will be subject to these instructions. Independent contractors will likely set their own rules. Types of instructions can include: when to work, where to work, what equipment to use, where to buy supplies, what steps to take when working, and who to hire.
  • Degree of Instruction
    Degree of instruction says that employers have more control over workers when instructions are more detailed. The more detailed the instructions, the more likely the worker is an employee. But, some jobs require little instruction. So the main question here is whether the employer has the power to instruct in detail.
  • Evaluation System
    An evaluation system provides methodology for determining the quality of work performed. Evaluation systems for both employees and independent contractors often assess the work’s end result. For employees, however, there is usually the added evaluation of how the work was performed throughout the process.
  • Training
    Training occurs when a business provides lessons about how to do a particular job. For example, an employee hired to do technical writing will already be a proficient writer, but the employer will provide training about how to write for their specific business. Training is usually reserved for employees. Independent contractors are hired because they already know how to accomplish the tasks at hand.

Financial Control

An employer has financial control if they can dictate the monetary details of a worker’s job. Per the IRS, financial control factors include: significant investment, unreimbursed expenses, opportunity for profit or loss, services available to the market, and method of payment.

  • Significant Investment
    Significant investment speaks to if tools have been acquired to perform a specific job. There is no set amount of money that must be reached for significant investment to occur. Usually, independent contractors will supply their own equipment, whereas employees will be provided with the tools they need. However, plenty of jobs can’t be easily categorized in this way. For example, staff photojournalists may be required to use their own cameras and equipment. Mechanics may need to have their own tools at the shop. In cases like these, workers can be considered employees even though they’ve significantly invested in job-related equipment.
  • Unreimbursed Expenses
    Unreiumbursed expenses are work-related payments for which employers do not pay back workers. While it is more typical for independent contractors to have unreimbursed expenses than employees, employees are not immune to such costs. (Think: teachers buying classroom supplies if a school fails to do so, or a remote employee paying for home internet.)
  • Opportunity for Profit or Loss
    The opportunity for profit or loss of money can indicate whether someone is an employee or independent contractor. Usually, if a worker has significant risk or benefit on the table, they are an independent contractor. For employees, the employer will usually absorb any profit or loss.
  • Services Available to the Market
    While all types of workers might offer their services to the market beyond a specific job, independent contractors are more likely to do so. They might maintain a website or office space, and may put ads out in the community.
  • Method of Payment
    Method of payment determines how and when a worker is paid. Employees are usually promised specific wages, consistently paid (weekly, biweekly, monthly, or some other predetermined schedule). Independent contractors, on the other hand, are usually paid a set amount for a particular job. Contractors may also be paid hourly, though often not to exceed a certain amount. Payment may occur before work is performed, immediately after work is performed, or at some other later date. (For example, freelance writers may not be paid until after a work is published.)

Type of Relationship

Type of relationship is determined by how workers and businesses understand the nuances of their arrangement. The IRS identifies four worker/business relationship factors: written contracts, employee benefits, relationship permanency, and services provided as key business activity.

  • Written Contracts
    Written contracts often state whether a worker is an employee or independent contractor. However, this does not guarantee that the IRS will classify the worker the same way the contract does. How a specific business relationship plays out will determine whether the IRS classifies the worker as an employee or independent contractor.
  • Employee Benefits
    Employee benefits include health insurance, 401ks, paid time off, disability leave, and parental leave, among other potential perks. As the name suggests, employee benefits are usually reserved for employees. That said, not all businesses provide employee benefits, or they may only provide benefits for certain employees. For example, part-time employees are often not eligible for their business’s health insurance.
  • Relationship Permanency
    Relationship permanency determines how long a business relationship is supposed to last. Independent contractors are usually hired for a set amount of time or to complete a specific project, whereas employees are generally hired without an end date.
  • Services Provided as Key Business Activity
    How essential a worker’s services are to a business can help determine whether they’re an employee or independent contractor. The more key the services, the more likely the worker is an employee. For example, if an advertising agency hires a copywriter—a job that is arguably essential for the creation of advertisements—this worker would likely be considered an employee.

Note, however, that it can be more difficult to classify workers as independent contractors in some states than in others. California, for example, changed its independent contractor rules in 2020 with law AB5. To qualify as an independent contractor in that state, you must pass the “ABC test.” The test says you’re only an independent contractor if you’re free from control, do types of work outside the business’s typical purview, and have a separate business of your own.

Employee vs. Independent Contractor Tax Filings

No matter what kind of workers you have, you need to submit the proper tax documents to them and to the IRS.

What tax form do employees need?

Employees need to receive form W2. You’ll send copies to the IRS as well.

What tax form do independent contractors need?

Independent contractors need to receive form 1099-NEC. (Form 1099-MISC was the required filing until 2020.) Just like with W2s, you’ll also send copies to the IRS.

What is the deadline for distributing tax forms to workers?

The deadline for distributing tax forms to both employees and independent contractors is January 31. If January 31 falls on the weekend or a holiday, the deadline is the next business day.

What happens if I miss the filing deadline?

You’ll pay a fee. How big of a fee depends on how late you are. (The fees are the same whether you’re filing W2s or 1099s.)

  • 30 days past the deadline: $50 per return, up to $556,500 for large businesses or $194,500 for small businesses.
  • 31 days late until August 1: $110 per return up to $1,669,500 for large businesses or $556,500 for small businesses.
  • After August 2 or never: $270 per return up to $3,339,000 for large businesses or $1,113,000 for small businesses.
  • Intentional Disregard: $550 per return with no limit.

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