When welcoming a new team member, you must be able to categorize them as employees or independent contractors. This way, you can ensure you remain in compliance with appropriate regulations.
In this guide, we explain the distinctions between an independent contractor and an employee and their significance in the business realm.
An employee is an individual who works under the supervision or control of an employer. The parties establish the employer-employee relationship with an employment contract. Employees can be either part-time or full-time and are eligible for various degrees of employee benefits.
An independent contractor is an entity, either an individual (a freelancer) or a company, hired by an employer to complete specific projects and tasks defined in an independent contractor agreement. They are usually equipped with specialized skills or knowledge and enjoy the flexibility of working for multiple companies.
Here’s a brief overview of the employment laws:
The US Department of Labor implemented a new rule in 2024 for classifying workers. It displaces the 2021 rule’s narrower scope, explaining that the classification of independent contractors and employees is subject to the “totality-of-circumstances” test. [7]
There are six factors that the Department of Labor evaluates to classify a worker:
Here are some examples of each factor:
| Factor | Employee Example | Independent Contractor Example |
|---|---|---|
| 1. Opportunity for profit and loss | A writer receives a regular salary from a publisher and gets assignments assigned to them. | A writer pitches topic ideas to various publications, negotiates contracts, and sets their own rates. |
| 2. Investments by the employer/worker | An IT support specialist operates entirely under a company's framework and doesn't purchase their own equipment to use for their job. | An IT support specialist maintains their own office space and buys advanced software and diagnostic tools. |
| 3. Work relationship permanence | A music teacher works for a music academy and plans to remain employed with no fixed end date. They don't actively seek out other students/clients. | A music teacher works with various clients and accepts teaching assignments depending on student availability. |
| 4. The nature and degree of control | A dietitian follows a hospital's protocols for creating diet plans and providing patient care. | A dietitian works outside the scope of a hospital and has more autonomy in their work. |
| 5. Whether the work is integral to the company's operations | A software developer maintains a company's core software programs and applications. | A software developer works on an application for a company, but the application isn't central to the business's operations. |
| 6. The skill/initiative involved | A photographer works for a magazine and executes their vision/goals. | A photographer uses their skills to attract and retain clients independently. |
Before 2020, hiring entities used the IRS 20-point checklist [8] to help determine independent contractor or employee status.
Now, the IRS has applied a less complicated approach to an independent contractor test [9] by distilling the 20-point checklist into three categories:
First, the IRS examines the degree of control an employer exerts over when, where, and how an employee works.
Employees:
Independent Contractors:
Next, the IRS considers how much responsibility the employer holds concerning the financial aspects of the worker’s job.
Employees:
Independent Contractors:
Regardless of what’s in the employment contract, the IRS determines a worker’s status based on how the employment relationship is actually carried out. If the worker is hired for an indefinite period of time, provides services that are a key business activity, and enjoys benefits, the worker is likely an employee in the eye of the IRS.
Employees:
Independent Contractors:
Explore the tax obligations for employees and independent contractors:
The government must collect its tax money to conduct its operations, so it relies on each business to correctly classify every member of its workforce. Misclassified workers can cost the government money and the business for the associated penalties.
Here are some potential consequences of misclassification:
Sometimes, the IRS can assess the situation and forgive employers when they think it was an honest mistake. Nevertheless, if the IRS deems the misclassification intentional, the misclassification is considered fraud, and the guilty party may face criminal prosecution and even jail time.
Consulting with legal and tax professionals is advisable to ensure compliance with relevant laws and regulations.
Understanding the difference between an independent contractor and an employee requires careful consideration, and both types of employment come with unique advantages and disadvantages.
Whatever relationship you choose for yourself or your workers, establishing terms and conditions in black and white is a crucial way to protect yourself and your business.
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