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Understanding What an Independent Contractor Is

Patrick Proctor
Patrick Proctor

Before deciding whether to hire a full-time employee or use independent contractors, you need to have a clear understanding of the differences.

  • An independent contractor works for themselves and is not technically employed by the companies they do jobs for.
  • Employers have control over the work an independent contractor does for them, but not how it is completed.
  • Independent contractors submit invoices for their work, and the company paying them does not take taxes out of the payments. Instead, independent contractors are subject to self-employment tax.
  • This article is for small business owners and supervisors who want to learn the key differences between an independent contractor and an employee and when independent contractors are typically used.

What is an independent contractor?

An independent contractor, as defined by Law.com, is an individual or business who performs services for another person or entity with a contracted understanding between the parties. With all of the terms spelled out – such as duties, pay, and the amount and type of work – the contracts govern what the work is more than how the work is executed. An independent contractor is distinct from an employee who works regularly for a single employer.

Independent contractors are not employees of the business or entity they are providing services for. However, the employer is paying the independent contractor for their work. Independent contractors are self-employed (also known as a "business for self"), which means they can operate and work for several clients at a time. Companies often use independent contractors for services to avoid bringing employees on staff for short-term needs.

Key takeaway: Independent contractors are typically project-based workers who have autonomy in how they complete the work as long as they complete it as agreed.

What are the differences between an independent contractor and an employee?

Both the Department of Labor (DOL) and the Internal Revenue Service (IRS) maintain important definitions and rules for independent contractor status. The IRS's general rule is that an individual is considered an independent contractor if the payer of the services can only control the result of the body of work, not necessarily how it is completed. The independent contractor completes IRS Form W-9, and an employee completes the IRS W-4 tax form.

Independent contractors

Independent contractors are self-employed; the money they make working as an independent contractor is subject to self-employment tax. They supply their own work tools and must submit invoices for payment.

Employees

Employees of a company perform services that can be controlled by an employer, including what works needs to be done and how it should be completed. This definition also applies to exempt employees, who have the autonomy to operate within their role as the employer sees fit, so long as the outcome is acceptable. What matters to the DOL is whether the employer has the legal right to control the details of how and when services are performed.

Further, employees cannot also be an independent contractor for their employer. Thus, their earnings are generally not subject to self-employment tax. However, their earnings as an employee may be subject to FICA (Social Security tax and Medicare) and income tax withholding, which the employer typically takes out during payroll processing. The employer provides work-related tools and the necessary gear. Although employees may fill out timecards, they do not submit monthly invoices for payment.

To deliver this messaging in a straightforward way, this chart from ComplyRight shows the stark differences between the independent contractor and employee classifications.

Misclassifying independent contractors

Misclassification of independent contractors can get employers in big trouble with the DOL and IRS. The IRS has strict definitions to determine whether a worker is an employee or an independent contractor. It is critical for your business to classify all your workers accurately. By misclassifying a worker, you could be subject to some large penalties and fines.

To help avoid this error, the IRS has developed the IRS 20 Factor Test – Independent Contractor or Employee? You can check your needs and reasoning for wanting an independent contractor with this 20-point test to determine whether you should hire an independent contractor or an employee. This test is heavily used to determine when and how the IRS pursues employers in the U.S. for misclassifying workers.

These are the 20 factors used to evaluate the right to control and the validity of independent contractor classifications:

  1. Level of instruction: If the company directs when, where and how work is done, this indicates a possible employment relationship.
  2. Amount of training: Asking workers to undergo company-provided training suggests an employment relationship, since the company is directing the methods by which work is accomplished.
  3. Degree of business integration: Workers whose services are integrated with the business operations or significantly affect the business's success are likely to be considered employees.
  4. Extent of personal services: Companies that insist on a particular person performing the work assert a degree of control that suggests an employment relationship. In contrast, independent contractors typically are free to assign work to anyone.
  5. Control of assistants: If a company hires, supervises and pays a worker's assistants, this control indicates a possible employment relationship. If the worker retains control over hiring, supervising and paying helpers, this arrangement suggests an independent contractor relationship.
  6. Continuity of relationship: A continuous relationship between a company and a worker indicates a possible employment relationship. However, an independent contractor arrangement can involve an ongoing relationship for multiple, sequential projects.
  7. Flexibility of schedule: People whose hours or days of work are dictated by a company are apt to qualify as its employees.
  8. Demands for full-time work: Full-time work gives a company control over most of a person's time, which supports a finding of an employment relationship.
  9. Need for onsite services: Requiring someone to work on company premises – particularly if the work can be performed elsewhere – indicates a possible employment relationship.
  10. Sequence of work: If a company requires work to be performed in a specific order or sequence, this control suggests an employment relationship.
  11. Requirement for reports: If a worker must provide regular written or oral reports on the status of a project, this arrangement indicates a possible employment relationship.
  12. Method of payment: Hourly, weekly and monthly pay schedules are characteristic of employment relationships, unless the payments simply are a convenient way of distributing a lump-sum fee. Payment on commission or project completion is more characteristic of independent contractor relationships.
  13. Payment of business or travel expenses: Independent contractors typically bear the cost of travel or business expenses, and most contractors set their fees high enough to cover these costs. Direct reimbursement of travel and other business costs by a company suggests an employment relationship.
  14. Provision of tools and materials: Workers who perform most of their work using company-provided equipment, tools and materials are more likely to be considered employees. Work largely done using independently obtained supplies or tools supports an independent contractor finding.
  15. Investment in facilities: Independent contractors typically invest in and maintain their own work facilities. In contrast, most employees rely on their employers to provide work facilities.
  16. Realization of profit or loss: Workers who receive predetermined earnings and have little chance to realize significant profit or loss through their work generally are employees.
  17. Work for multiple companies: People who simultaneously provide services for several unrelated companies are likely to qualify as independent contractors.
  18. Availability to public: If a worker regularly makes services available to the general public, this supports an independent contractor determination.
  19. Control over discharge: A company's unilateral right to discharge a worker suggests an employment relationship. A company's ability to terminate independent contractor relationships generally depends on contract terms.
  20. Right of termination: Most employees can terminate their work for a company without liability. Independent contractors cannot terminate services without liability, except as allowed under their contracts.

Key takeaway: Independent contractors are not employed by the company they contract with; they are independent as long as they provide the service or product agreed to. Employees are longer-term, on the company's payroll, and generally not hired for one specific project.

What are common examples of independent contractors?

There are many fairly routine examples of independent contracting functions or roles within business today.  

Freelance writers and graphic designers

Freelance writers generally work as independent contractors, writing articles and then selling the articles to publications. Similarly, freelance graphic designers may create graphics for many companies' one-off projects. Work product is outlined in an agreement and then executed in a way that the freelancer sees fit, and they are compensated per task they accomplish.

Real estate agents

Typically, real estate agents work independently, but within a larger network or an agency that helps process the commissions in exchange for shepherding a sale.

IT professionals

Some IT professionals are independent contractors. This can be a tricky one, as many IT professionals are employees. If they are performing short-term or specific project work that has a completion timeline in place, they are typically operating within an independent contractor role.

Key takeaway: Freelance writers, graphic designers, real estate agents and some IT professionals are examples of independent contractors. The common thread is that they have autonomy even though they may operate with a larger network, team or agency.

What are the best practices for working with independent contractors?

When working with independent contractors, you can use several simple tactics to keep yourself out of hot water with the IRS and also ensure the work meets your needs.

1. Do not treat independent contractors like employees.

It is important not to blur the lines between contractor and employee. Do not allow independent contractors to use company equipment that they should already have. For jobs like writing and graphic design, contractors generally do not work onsite.

2. Use a written contract.

Never allow a contractor to begin work on behalf of your company without a fully executed contract or agreement. This document is what outlines your relationship with the independent contractor, and it is essential to stick to its parameters throughout your relationship.

3. Do not allow grossly extended timelines.

This is an all-too-common mistake the IRS finds employers making with independent contractors. If you need long-term work from the contractor, the DOL and the IRS will eventually wonder if you should have a regularly scheduled employee in that role.

Key takeaway: When working with independent contractors, do not treat them like employees, always have a written contract, and do not allow extended timelines. If you nail these three best practices along with the IRS 20 Factor Test, you will be in good standing.

Patrick Proctor
Patrick Proctor,
Business News Daily Writer
Patrick Proctor, SHRM-SCP, is certified as a senior professional in human resources. He has consulted and operated at the C-suite and executive levels for more than 15 years. Patrick actively maintains expertise within the worlds of human resources, organizational development, operations management and corporate social responsibility. Patrick is a contributor to business.com and Business News Daily, writing about HR and business management topics impacting leaders.