What’s the Difference Between Employees and Independent Contractors?
The main distinction between employees and independent contractors is the level of control an employer has over their work. Generally, independent contractors:
- Set their own schedules.
- Use their own tools and equipment.
- Pay self-employment taxes.
- Work with minimal supervision.
- Often serve multiple clients.
Employees, on the other hand, have closer oversight, benefit from workplace protections like minimum wage and overtime laws, and are subject to tax withholding by their employer.
The IRS uses three key factors to classify workers:
- Behavioral control: How much direction the employer gives on tasks and processes.
- Financial control: How the worker is paid and whether they can expense costs.
- Relationship type: Whether benefits like health insurance are provided and if the role is ongoing.
Independent contractors are usually considered self-employed, but state regulations may vary. Common contractor roles include consultants, freelancers, and temporary project-based professionals. Employees, however, cover a broad spectrum of roles, from office staff to medical personnel.
Tax Responsibilities for Employers
Employers have far more tax responsibilities for employees than for independent contractors. For example, they must handle tax withholding for multiple types of taxes, including:
- Federal income tax.
- State income tax, if applicable.
- Payroll taxes, including Social Security and Medicare.
- Federal and state unemployment taxes.
Employers must also submit several tax documents to remain compliant, including:
- Employment tax payments – Withhold and remit federal and state taxes.
- Form W-2 – Reports employee wages and withholdings.
- Form 941 – Quarterly payroll tax return.
- Form 940 – Covers federal unemployment insurance.
- Form 1095-C: Covers health insurance provided to employees.
- Form 5500: Covers employer-sponsored retirement plans.
Employers may face additional employment-related costs aside from tax liability. These include the costs of benefits provided to their employees. In some states, employers may be required to pay into a state fund that provides paid leave and similar benefits. They may also have to pay for workers' compensation insurance.
What Are the Tax Implications of Hiring Independent Contractors?
Employers must provide Form 1099-NEC to any independent contractors who received at least $600 in compensation during the tax year. Employers must also file Form 1096, which summarizes the 1099 information, with the IRS.
Payments to independent contractors are deductible as business expenses. Payroll expenses are also tax-deductible, but employers may be able to save money by using independent contractors instead of employees. They are not liable for payroll taxes for independent contractors, nor are they bound by laws dealing with minimum wage, overtime, and other employment-related issues. They are also not required to provide benefits to independent contractors.
That said, employers can only expect to save money when they use independent contractors legitimately and legally. Some employers misclassify workers—intentionally or unintentionally—to reduce costs or bypass legal requirements. Employee misclassification is against the law and could expose an employer to significant monetary damages.
What Are the Risks of Misclassifying Workers?
Employee misclassification is unlawful at both the federal and state levels. Employers who wrongfully classify employees as independent contractors may face fines from government regulators. They could also be required to pay the employment taxes they should have been withholding, as well as unpaid unemployment taxes. Misclassified employees may be able to sue for damages, including the value of benefits they should have received.
Employers who are unsure about a worker’s status can file Form SS-8 to request the IRS to determine the worker’s classification. However, the determination might not fit with other worker classification laws. For example, the standard the IRS uses to determine classification for tax purposes is not necessarily the same as the one the Department of Labor uses to determine compliance with minimum wage and overtime laws.
When Should You Hire an Employee vs. an Independent Contractor?
Employees are likely to be a better fit for an employer’s long-term needs, such as positions where consistent output or institutional knowledge will be important. Jobs that require a large amount of oversight or control are also best suited for employees. This might include jobs that handle something of value, such as bank employees, or jobs where employers have strict legal duties, such as law firms or medical practices.
Scenarios that might be ideal for contractors often involve short-term work or work that is outside of the employer’s usual business. Project-based work, for example, might attract freelancers, who can be free to move on to a new job once a project ends. Employers who need specialized skills for a limited time could benefit from independent contractors.
It is not always immediately apparent whether an employee or an independent contractor would be best for a particular role or position. Employers may need to do cost-benefit analyses for each option in different scenarios.
How Can You Ensure Compliance With Tax Laws?
Employers can improve compliance with tax laws by following these steps:
- Know which laws apply and what they require, such as the Fair Labor Standards Act and the Federal Insurance Contributions Act.
- Maintain written contracts for both employees and independent contractors.
- Keep accurate and detailed records of employee pay and benefits.
- Keep accurate and detailed records of independent contractor compensation.
- Make timely tax payments, particularly for amounts withheld from employee paychecks.
- File all tax forms in a timely manner. Keep a calendar of quarterly and annual due dates.
- Consult with a tax professional or legal advisor who can monitor compliance.
- Consider having audits performed by a third-party auditor.
What’s New for 2024/2025?
The legal standards for worker classification under federal law may change in 2025. The Department of Labor modified the standard it uses for the Fair Labor Standards Act in early 2024. This is the law that governs minimum wage and overtime pay nationwide.
The 2024 rule change rescinded a rule adopted in 2021, which had made classifying a worker as an independent contractor easier. The new rule generally favors employees.
Deciding between employees and contractors is more than a tax choice—it’s also about ensuring compliance and building a strong team. Need help classifying workers correctly? Get expert guidance from a Rocket Legal Pro.
This article contains general legal information and does not contain legal advice. Rocket Lawyer is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.
