What is the difference between an employee and an independent contractor?
Takeaway: Different jurisdictions have different standards, which makes classification complicated. In general, the more influence the company has over how the work is performed, the more likely the individual is an employee. California uses the ABC test and New York and the IRS use the common law test.
As a business owner, it’s important to understand the difference between employees and independent contractors. The distinction between the two is important for legal, tax, and compliance purposes. In general, if a business has control over how and when work is completed, provides training, and provides tools and equipment, the worker is likely an employee. If a worker has more control over how and when work is completed and provides their own tools and equipment, they are likely an independent contractor.
California uses a test called the ABC test to determine whether an individual is an employee or contractor. Other states (including New York) and the IRS use what is called the common law test.
Employee
An employee is someone who works for a company under the direction and control of the employer. Employees are typically paid a salary or hourly wage and receive benefits such as health insurance, retirement plans, and paid time off. Employers are responsible for withholding taxes from an employee’s paycheck, paying unemployment taxes, and complying with labor laws such as minimum wage and overtime requirements. Employers may also provide training, tools, and equipment to employees.
Independent Contractor
An independent contractor is someone who provides services to a company under a contract. Independent contractors work independently and have control over how they complete the work. They are typically paid a flat fee or hourly rate and are responsible for paying their own taxes. Independent contractors are not eligible for employee benefits such as health insurance or retirement plans. Employers are not responsible for withholding taxes or complying with labor laws such as minimum wage and overtime requirements. Independent contractors may provide their own tools and equipment and are typically not provided training by the employer.
California’s ABC Test
Under the ABC test, a worker is considered an employee and not an independent contractor, unless the hiring entity satisfies all three of the following conditions:
The worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact;
The worker performs work that is outside the usual course of the hiring entity’s business; and
The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.
Common Law Test
Under the common law test, an individual is evaluated based on the behavioral control, financial control, and relationship of the parties. If the employer controls any of these, then the individual is an employee. This has obvious interpretation issues for companies and classification at the margins ends up being a case-by-case analysis.
Misclassification issues
It’s important for businesses to properly classify workers as employees or independent contractors. Misclassification can lead to legal and financial consequences. Misclassifying employees as independent contractors can have significant legal and financial consequences for businesses. Here are some of the dangers of misclassification:
Tax Liability: Employers are responsible for withholding payroll taxes from employee paychecks and paying the employer portion of payroll taxes. If an employer misclassifies an employee as an independent contractor, they may be liable for back taxes and penalties for failing to withhold and remit payroll taxes.
Labor Law Compliance: Employers are subject to labor laws such as minimum wage and overtime requirements, workers’ compensation insurance, and unemployment insurance. Misclassifying employees as independent contractors can result in violations of these laws and potential fines and penalties.
Benefits and Protections: Employees are entitled to certain benefits and protections such as health insurance, retirement plans, and protections under anti-discrimination and anti-harassment laws. Independent contractors are not entitled to these benefits and protections. Misclassifying employees as independent contractors can result in a loss of benefits and protections for workers.
Legal Liability: Misclassifying employees as independent contractors can result in legal liability for the business. For example, if an independent contractor is injured on the job and is later determined to have been misclassified as an independent contractor, the business may be liable for workers’ compensation benefits and other damages.
Conclusion
Misclassifying employees as independent contractors can have significant legal and financial consequences for businesses. Employers should properly classify workers to avoid tax liability, labor law violations, loss of benefits and protections, legal liability, and reputational damage.