- An employee is on a company's payroll and receives wages and benefits in exchange for following the organization's guidelines and remaining loyal.
- A contractor is an independent worker who has autonomy and flexibility but does not receive benefits such as health insurance and paid time off.
- Misclassifying a worker can result in back taxes, fines, penalties and legal disputes.
- This article is for business owners who want to understand how to classify their workers.
Hiring a contract worker rather than a full-time employee could save your business money; after all, you won't have to pay for a contractor's health insurance, 401(k) matches, vacation time or other benefits. However, choosing this option also comes with limitations and potential risks. Before you decide which type of worker to use for a given role, it is important to understand the differences between contractors and employees and the consequences for misclassifying workers.
What is a contractor?
A contractor – also called a contract worker, independent contractor or freelancer – is a self-employed worker who operates independently on a contract basis. A contractor is not an employee; instead, they run their own entity (such as a sole proprietorship, limited liability company or limited liability partnership) and are contracted out by organizations to work on particular projects or assignments. Their contract relationships can be short- or long-term. A contractor can work for a company but is not technically on their payroll. They can also do work for multiple companies at one time.
Key takeaway: A contractor is a self-employed worker who operates on a contract basis for clients.
Contract worker versus employee
There are many differences between a contractor and an employee. Here are some factors to look at when distinguishing between the two:
Payment, taxation and benefits
One of the biggest differences between contractors and employees is the way they are paid and taxed. An employee is on a business's payroll, so the company pays the employee their hourly wage or salary and withholds the appropriate taxes (e.g., federal income tax, Social Security tax, Medicare tax). An employer often pays for employee benefits as well. These can include mandatory employment benefits, like health insurance, and other desirable benefits, like flexible spending accounts (FSAs), health reimbursement accounts (HRAs), health savings accounts (HSAs), paid vacation, commuter benefits and stock options. [See our reviews of HR software to help you track employee benefits, taxes and payroll.]
On the other hand, that same organization would pay a contractor an agreed-upon wage for their services but would not withhold or pay any taxes. A contractor is responsible for paying their own taxes, including federal income tax and self-employment tax. Additionally, they must pay for and obtain any benefits they want, including health insurance, independently.
Another major difference between a contractor and an employee relates to their level of independence.
"Most people think the only difference between an independent contractor and an employee is how they are paid," Michael C. Harman, attorney at Harmon Law, told Business News Daily. "In addition to compensation, independent contractors have more autonomy in the work they perform."
Harman noted that employees are hired to perform specific work at the direction of the employer. Independent contractors, on the other hand, are typically given a job or project to work on without the company controlling when and how they do it, he said.
Onboarding and training
The onboarding and training processes also differ greatly between contractors and employees. Because contractors are expected to focus on a specific project, they are often given only the information that's critical for completing that task, said Kimberly Schneiderman, senior practice development manager at Randstad RiseSmart. Full-time employees, in contrast, require lengthy onboarding processes to understand the intricacies of team dynamics, the company culture and overall goals.
Schneiderman said the hiring goals for employees and contractors are also different.
"While companies work to make sure full-time employees are engaged and work to gain loyalty, these same organizations need to realize that their contractors are always looking for the next gig and are not invested in long-term outcomes as full-time employees are expected to be," she said.
Instead of focusing on long-term loyalty, as they would for someone with employee status, many businesses prioritize a contractor's niche expertise. Many companies seek this knowledge or skill set for specific projects or assignments, even if that means using these contractors for the short term.
Another difference between an employee and a contractor is the degree of flexibility they have in their work. An employee works for one company and is therefore subject to the rules and obligations set forth by that company. A contractor, by contrast, has the choice to work for one or multiple organizations; in fact, it is common for contract workers to juggle several clients at one time.
This level of flexibility can be seen as a benefit or a limitation, depending on what type of work-life balance the person is seeking. For example, contractors can take time off whenever they feel like it, but they do so at the cost of not making money during that time.
Key takeaway: Differences between contractors and employees involve pay, taxes, benefits, autonomy, flexibility, expertise, onboarding and training.
How to distinguish an independent contractor from an employee
The IRS looks at certain factors to see if a worker should be classified as an independent contractor or an employee of a company. Attorney Christy L. Foley said these questions can help you determine how to classify a worker:
- When, where and how is the work done? Is the work performed at the employer's place of business, or does the independent contractor work remotely? Does the employer set the hours, or can the independent contractor work whenever they want? Does the employer provide the tools, or does the independent contractor use their own equipment?
- Is the worker required to complete company training?Independent contractors usually do not have this requirement.
- Is the worker doing full-time, ongoing/continual work? Or are they doing temporary work on projects that have specific end points?
- Is the worker paid hourly, weekly or monthly?Or do they get paid once an entire project is complete?
- Does the company pay for travel?For employees, travel costs are usually covered by the company. Independent contractors, however, pay their own travel costs (and earn enough on the overall project that those costs end up being covered by the fee they're paid).
"Technically, the IRS has about 20 factors that it looks at in determining whether someone's an employee or an independent contractor," Foley said. "However, the ones listed above are the most commonly used."
Key takeaway: When determining whether to classify workers as an employee or a contractor, consider when, where and how they do the work; how they're paid; and whether company-specific training is required, among other factors.
What happens if a worker is misclassified?
The consequences for misclassification vary depending on whether the misclassification is deemed intentional.
"Typically, a company will [be] required to pay back taxes, as well as fines and penalties that can be based on the number of IRS Form W-2s that the company failed to file because of the misclassification and a percentage of wages in which the company failed to withhold the proper taxes," Harman said.
In extreme cases, he said, businesses could face criminal penalties, and a worker who has been misclassified could be entitled to overtime pay for time worked in excess of 40 hours per week, as well as additional monies, such as punitive or liquidated damages if the worker is successful in a lawsuit against the company.
Foley added that, besides monetary consequences, there can also be disputes over who owns the work that was created.
"Employees' work is typically owned by the business," Foley said. "Independent contractors' work has to be signed over to the company in a separate contract."
Key takeaway: Worker misclassification can have monetary and legal repercussions.
Additional reporting by Skye Schooley. Some source interviews were conducted for a previous version of this article.