A common mistake by entrepreneurs is hiring people as independent contractors when they are actually employees in the eyes of the law. Why does this happen? Well, with independent contractors you don’t need to worry about the plethora of employee obligations like tax withholding, social security and Medicare taxes, unemployment insurance contributions, overtime, or employee benefits. Financial incentives aside, people get it wrong because the law on classifying workers as employees (whose pay is reported on a W-2) or independent contractors (whose pay is reported on a 1099) isn’t simple. A transport company got it wrong with its drivers who had control over certain aspects of their work and supplied their own vehicles but were found to be employees based on the amount of control the company could and did assert over them. A ride-hailing company was put in a similar situation and has settled with many of their drivers over their status.
A tech company is in a similar hot seat with freelancers it hired from a staffing agency who are now claiming that they were controlled by the company in ways too similar to W-2 employees.
When an employer misclassifies an employee as an independent contractor, they may get stuck with back taxes and penalties, overdue payments to state programs, employee benefits claim, and costly litigation initiated by disgruntled workers.
So how can you tell if your worker is an employee or an independent contractor? Unfortunately, because this classification is used for a wide variety of purposes ranging from federal tax obligations to state wage and hour laws, there are a variety of tests that are used. A worker may be classified as an independent contractor under one test but as an employee under another. Despite the patchwork of tests that apply, the following is a list of important, albeit not exhaustive, factors that will steer you in the right direction.
| Factor | Employees | Independent Contractors |
|---|---|---|
| Control Over Behavior | Are told by the employer how, when, and where to do the work. | Have the latitude to decide how, where, and when to perform the work to achieve the end goal set by the company. |
| Supplies | Are provided with the tools, e.g., computers and software, to perform the work. | Have invested in and provide their own tools for completing the work. |
| Exclusivity | Work for a single employer. | Are hired by different clients simultaneously and seek out work assignments from other clients. |
| Permanency | Continue to work for employer for an indefinite period of time. The relationship ends when the employee resigns or is otherwise terminated. | Work until the project is completed as specified in the contract. The ability to terminate the relationship is dictated by the contract. |
| Opportunity for Profit or Loss | Won’t risk losing money by performing the work. | Are exposed to the risk of losing money because they supply their own equipment and generally are not reimbursed for expenses. |
| Significance | Perform work that is core to the company's business. | Perform work that is ancillary to the company's business. |
As an illustration of these factors, if the project is to build a website, the employee is told what web editor to use, is shown what the website should look like, is provided with a computer and software, is expected to do the work at the company’s office during business hours and will maintain the website as part of her on-going job. In contrast, the independent contractor who is hired to build the website decides what web editor she is going to use, does the work on her laptop where and when she chooses, determines what the website will look like within the scope of specifications listed by the company in her contract, and is currently designing a website for two other clients.
Some closing reminders as you navigate the difference between employees and independent contractors:
- Some states, like California and Massachusetts will legally presume that all workers are employees unless the employer can meet the state’s applicable test for an independent contractor.
- The label you give your worker doesn’t matter for classification purposes; you can’t transform an employee into an independent contractor by “dressing” them up with a contract and other features that are common with independent contractors. Check it out.
- Consistency matters. You shouldn’t have employees and independent contractors doing similar tasks under similar working conditions.
It makes sense to understand the basic differences between employees and independent contractors so that you can protect your company from worker misclassification problems and keep your company compliant with labor laws right from the start.
Organizing in Fidelity can help ensure your company is compliant.
Fidelity does not provide legal or tax advice. The information herein is general in nature and should not be considered legal or tax advice. Consult an attorney or tax professional regarding your specific situation.
Sample scenarios are for illustrative purposes only.
Third parties mentioned and Fidelity are not affiliated.
Included are links to websites that are unaffiliated with Fidelity. Fidelity has not been involved in the preparation of the content supplied at the unaffiliated site and does not guarantee or assume any responsibility for its content.
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