Independent Contractor vs Employee: What’s the Difference?

Erez Greenberg April 15, 2021
Independent Contractor vs Employee

How you classify your workers matters — fact. Companies that are mis-classifying contractors have been facing steep fines.  If you’re wondering what the differences are between an independent contractor and an employee, you’re in the right place. Let’s look at a quick definition of both types of worker, and how that makes a difference in practice.

Employees 

The IRS says that an employee is anyone who works for you where you define “what will be done, and how it will be done.” For example, you could tell an employee where they need to work from, or how much you’re going to pay them for that work.

An employee is a predictable cost for a business, as they are usually paid a fixed salary, but they are also a comparatively expensive outlay, as their costs will include benefits such as Paid Time Off, taxes, and extras such as expenses or training. There is a lot more operational complexity involved in hiring an employee over a contractor. For example, you’ll need to pay Social Security taxes, Medicare and Unemployment, as well as Health insurance, 401k matching, Disability insurance and Worker’s compensation.

Independent Contractors

In contrast, according to the IRS, an Independent Contractor gets much more control over how they work, and all that you as the employer get to define is “the result” of the work. Elements such as the pay, the location, or the hours of the worker are under their own terms. This is a perfect arrangement for employers who want to gain a niche skill quickly, or augment an in-house team with some specialist expertise or more manpower for a specific project.

The costs are generally lower, but far less predictable, as the contractor may be charging by the hour, and you have less control over the end price. A freelancer or an independent contractor is responsible for filing their own taxes, and all you need to do operationally is fill out Form W-9.

Understanding Whether Your Worker is an Independent Contractor or an Employee

In some cases, it’s obvious which category your worker falls under, such as a full-time salaried lawyer who completes their work from your law-firm’s offices, and only works with your company’s clients. This is clearly an employee. At the same time, an ad-hoc graphic designer who you take on for occasional limited design work when they’re available, and according to their own pre-defined rates is very distinctly a freelancer or an independent contractor.

However, in other cases, the differences will be more difficult to distinguish. Let’s say for example that you have a member of staff who lives and works abroad. They work in their own time zone, and you pay them in their local currency, but they provide 40 hours per week of work for your company, and you set the rates and the scope of what they do. Not so simple, right? How about a local worker who you onboard as a freelancer, but agrees to a set amount of work on retainer each month, and asks you to provide their expensive working equipment or looks to you for professional development opportunities? Neither of these cases are black and white.

Today’s global working reality has made this even more complicated. For a worker to be an employee of a US-based company, they need to be eligible to work in the US. Many companies mistakenly believe they can get around this by onboarding overseas workers as contractors. However, in reality they either need to open a legal entity in the region in which the candidate is working, or utilize an Employer of Record relationship. 

Is There a Quick Rule for Employee vs Independent Contractor?

If you’re trying to understand how to classify your workers correctly, there are three elements to consider. These are:

  1. The financial control you have over the terms of the agreement.
  2. The behavioural control you have over the role, such as where and when the work is performed.
  3. The nature of the relationship, such as short-term or long-term, committed or ad-hoc.

This article on contractor misclassification breaks down these three elements in more detail to help you to navigate this area with more clarity.

If you’re still not sure which designation your worker needs, you can ask the IRS to make the decision for you, by filling out this form. 

Helpful Resources for Employee vs Independent Contractor

Internal Revenue Service, “Understanding the Employee vs Contractor Designation”

https://www.irs.gov/newsroom/understanding-employee-vs-contractor-designation

MIT, “Estimating the Cost of an Employee”

https://web.mit.edu/e-club/hadzima/pdf/how-much-does-an-employee-cost.pdf 

Nolo: “Documentation Required to Work in the United States”
https://www.nolo.com/legal-encyclopedia/free-books/employee-rights-book/chapter16-3.html

US Dept of Labor: “Fact Sheet: What is an Employee Relationship under the Fair Labor Standards Act (FLSA)?”

https://www.dol.gov/agencies/whd/fact-sheets/13-flsa-employment-relationship

JD Supra: “A Decade of Examples of Contractor Misclassification”

https://www.jdsupra.com/legalnews/the-past-decade-of-independent-24702/

Papaya Global utilizes a specialized center of excellence model, with vast expertise and support on different types of employment, and how each will impact your business growth. Uniquely, we also offer a full range of global workforce solutions, including technology that manages everything from payroll employees and contractors, to Employer of Record relationships worldwide, so that you can get a single view of your whole workforce, no matter who that includes.

For more information, reach out here.

Papaya Global payroll platform lets you:

  • Automate payroll with zero processing errors
  • Manage global payroll, PEO & contractors via one platform
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