How to Determine a Contractor vs Employee

Contents

1. What is a contractor?
2. What is an employee?

3. What are the differences between contractors and employees?

4. What are the benefits and drawbacks of each classification?

5. Classifying contractors and employees for legal compliance

6. Checklist to determine the difference between contractors and employees

7. How to avoid common mistakes when classifying workers

8. Making worker classification seamless

If your organization (like a majority of companies today) works with hybrid teams, one of the first things you will need to do is establish a clear difference between permanent employees and contractors.

Sometimes, this difference between contractors vs employees is clear enough. The manager in the corner office who’s running a core organizational function and answering to the top management is obviously an employee of the company. The photographer who was specially engaged to come and shoot the company video that one time is a contractor.

But this difference is not always so stark. For example, if your organization offers flexible work hours and allows people to operate remotely from different locations, you might not be able to tell whether a worker is an employee or a contractor, right up front. 

But the two kinds of workers (contractors vs employees) have specific legal statuses and tax obligations, so it is mandatory for employers to classify them right. The key differences can be summed up as follows. Employees are salaried workers hired on a permanent contract, put on the company payroll and given all the statutory rights and benefits dictated by labor laws. Contractors are independent workers who are not hired by the company, but are simply brought on board for specific projects or requirements. They enjoy the flexibility, that comes with operating as an independent entity.

Do note – the term ‘contractor’ may encompass various kinds of workers as well. It may refer to a ‘freelancer’, who is a self-employed professional who works largely alone and has a niche area of expertise. It may also refer to a ‘contract worker’, who works under a vendor, an agency or an umbrella company. Learn more about these variations in this blog.

In this article, we will delve deeper into the differences between employees and contractors, and help you classify them correctly.

What is a contractor?

Contractors perform contract work as an outside employee, who may or may not also be self-employed. These are highly skilled individuals who operate their own businesses, offer specialized services, and work for themselves rather than an organization. They may be a customer care representative, IT infrastructure support, a project manager and more. They control their own work methods, schedules and take care of their own taxes.

What is an employee?

An employee is a person who works for another individual or company to complete work and assignments. Business owners pay employees for their work in order to grow and maintain their company. Employees frequently have a written employment contract with their employer that outlines their pay rate, hours and benefits in detail.

What are the differences between contractors and employees?

There are many nuances that determine worker status, but these factors can be a good starting point to differentiate between contractors vs employees.

• Working relationship

  Contractors are independent business owners, so your engagement with them can be defined as a business-to-business relationship. These relationships are usually contractual – with responsibilities, targets and payment terms specified within the contract. A contractor is free to establish more such relationships with other businesses simultaneously. They may or may not be available to take up any new requirement you have; nor are you obliged to continue working with them beyond the contract period.

  Your relationship with an employee is more permanent and indefinite – it only ends when the employee hands in their resignation, or if you terminate them on legitimate grounds. As an employer, you also have certain responsibilities towards your employees’ wellbeing and growth. In turn, you are entitled to all of your employees’ time during work hours – you can forbid them to take up any other work during that time.

• Working behaviors

Your employees can be told where to work from and could be asked to log in during specific hours. They can also be told how to do their jobs – a manager may guide them on day-to-day tasks, set their daily priorities and change those priorities as new requirements arise. Even if you trust your employees to do their work without oversight, you still retain the right to assert these controls if you so choose.

You cannot have the same degree of control over your contractors – either contractually, or in actual practice. As long as they meet the targets stipulated in their agreement, you cannot tell them where, when and how to work. Be careful about maintaining these boundaries – even asking a contractor to attend your daily huddles or other team events can inadvertently put them in the category of an employee!

• Responsibilities

Typically, an employee fulfils a core function of the organization, and as an employer, you can change or modify their set of responsibilities any time. You can re-skill an employee and allocate them to a new department, ask them to cover an extra shift, promote them to take on more significant roles and so on.

You cannot change your contractors’ set of responsibilities in the same way. Their roles continue to be dictated by the Statement of Work (SOW) in their contract and you cannot ask them to go beyond this to say, cover for someone who’s out sick or perform additional tasks. Any extra responsibilities you need them to take on, will have to be outlined clearly in a new contract. What’s more, depending on your state or country laws, you may not be allowed to assign contractors to fulfil core organizational responsibilities. A popular rideshare app in the US had to pay millions in settlements because they classified their drivers as independent contractors.

• Payments

You will need to pay your employees a regular salary, decided on a monthly or hourly rate. This is usually not dependent on the exact tasks they perform – they are still entitled to the same salary on slow months or during times when they’ve been asked to take on different duties. Additionally, employees may be entitled to annual bonuses and incentives based on company profitability.

A contractor is not entitled to a steady amount each month. They simply need to be paid the amount agreed upon, for the specific tasks you have engaged them to do. Once they have performed these tasks, they will raise their invoices, and you will need to make the payment within the stipulated time frame. They are typically not entitled to bonuses or incentives.

• Benefits and perks

  You are legally mandated to offer certain benefits (like paid time off, sick days, parental leaves, health insurance and more) to your employees, to ensure fair and reasonable working conditions. In addition, you may want to offer perks like a wellness and food allowances, transport reimbursements and so on. These are optional, but the better your perks, the more easily you are able to attract and retain top talent.

  Contractors are not entitled to any of these employee benefits or perks, and are expected to pay for their own insurance and health plans. They usually account for these when quoting their price, so you do not have to offer these separately to them.

• Taxes

As an employer, you are responsible for deducting a certain amount from an employee’s salary, as taxes. The amount and percentage to be deducted will be dependent on your state or country’s tax laws. These laws may also require you to contribute an employer’s share towards payments like Social Security and Medicare. In the US, these deductions are filed through the W-2 tax form (which is why employees are often referred to as W-2 workers) – but you will need to check and file the right paperwork based on your location.

Contractors are responsible for filing and managing their own taxes, so you do not need to make any deductions for them. Here too, you will need to find out what your tax responsibilities are (if any) in your jurisdiction. As a client in the US, you only need to record payments made to a contractor if it exceeds $600 in a year. The way to do this is by submitting a W-9 Form, gathering a contractor’s Tax Identification Number (TIN), and recording payments through the Form 1099 Misc.

• Training and up skilling

  As an employer, you are responsible for training your employees to handle specific project requirements. If they need to upskill or earn certifications to do their job, it is your responsibility to arrange and pay for these.

  Contractors are expected to keep themselves updated as per industry standards, and pay for their own upskilling and certifications. If their credentials don’t meet your standards, you can simply choose to work with a better qualified contractor.

• Financial obligations

  Finally, your employees should bear no financial obligations to work for you. You will need to provide all the equipment and resources they require to do their jobs. In case they incur certain (approved) expenses during the course of their work, you will need to reimburse them for that.

  Contractors on the other hand, need to purchase their own equipment and pay for any resources they use. They usually factor these in their contract rates so that it remains financially viable for them to do their jobs. But there may be unexpected circumstances (say, if their equipment breaks down during a project) when they will need to cover extra costs even if it exceeds their invoice rates.

Employees vs Contractors: What’s the difference?

What are the benefits and drawbacks of each classification?

Benefits of a contractor classification:

• Flexibility: By allowing firms to hire specialists for certain projects without making long-term commitments, contractors offer flexibility in staffing.
  
  
• Saving money: Since independent contractors are not eligible for employee benefits like retirement contributions or health insurance, businesses can save money on labor costs.
  
  
• Reduced admin: Simplifying HR duties, eliminating payroll taxes, and benefits administration can ease the administrative burden on businesses.
  
  
• Diverse talent: Access to a wide range of specialized talents and knowledge that may not be present in a typical workforce.
  
  

The drawbacks:

• Limited control: Because independent contractors have more freedom, it can be difficult to supervise their work as closely as employees.
  
  
• Potential for turnover: Because of their potential for mobility, contractors may require more frequent hiring and training of new employees.
  
  
• Legal risks: Misclassification can result in court cases, fines, and unpaid taxes if government officials mistake contractors for employees.
  
  
• Lack of loyalty: Contractors might not be as dedicated or committed to your business.
  
  

Benefits of an employee classification:

• Control: Employers have more control over their workers' labor, schedules, and tasks, which helps them to give consistent instructions.
  
  
• Loyalty: Employees frequently have a greater feeling of loyalty and devotion to the organization, which could result in more productivity.
  
  
• Development and training: Employers might spend money on training and development initiatives to raise their staff’s skill levels.
  
  
• Legal compliance: Accurate employment classification assures adherence to labor regulations, lowering legal risks.
  
  

The drawbacks:

• High costs: Costs are higher because employers must pay for benefits like paid time off, retirement programmes, and healthcare.
  
  
• More admin: Payroll, benefits, and HR-related responsibilities can be difficult and time-consuming to manage.
  
  
• Less flexibility: Workers might need a more organized work environment, which makes it more difficult to finish projects urgently.
  
  
• Legal obligations: Employers are required to make sure they are following labor laws, such as minimum wage pay, overtime pay, and workplace safety requirements.
  

Classifying contractors and employees for legal compliance

Adhere to labor laws

So why is misclassification such a big deal? An employer-employee relationship comes with certain tax and federal obligations. Both parties have to pay federal and state taxes, and make contributions towards social insurance systems. Employees also enjoy certain labor law protections that govern minimum wages, overtime pay, unemployment benefits and more. 

But when a company hires an independent worker, they do not have to make these contributions – nor do they have to ensure the rights and protections dictated by the employment laws.

Many unscrupulous businesses have seen this as an opportunity to cut costs. They get out of paying taxes, contributing to social schemes, complying with worker rights, or offering benefits – simply by misclassifying employees as independent contractors. One US-based construction collective gained notoriety with the way they changed their employees’ status overnight, thus stripping them of all their rights and protections, even though the workers continued doing the same job they were doing before.

Government bodies around the world have started cracking down on such unfair practices. In this case, the construction collective had to pay heavy fines, back taxes, damages and more. Last year, the US Department of Labor stepped up investigations to help identify and enforce cases of misclassification. Earlier this year, the Singapore government announced its decision to crack down on misclassification cases in an effort to safeguard worker rights under their Progressive Wage Model. EU member states are looking into the status of gig economy workers, and proposing that rideshare drivers and food delivery personnel should be classified as employees.

These are just a few examples. There are a lot of complexities involved in implementing these laws well, but one thing is fast emerging as an indisputable fact – misclassifying workers can have severe consequences in today’s labor landscape.

Penalties of misclassification

1. Tax fines

   An employer will be penalized for not paying the taxes and making the contributions that they rightly should have. They may be asked to pay back taxes, clear previous dues and pay fines. The exact amount will be determined as per local tax laws and may be considered on a case-by-case basis.
   

   In the US, an employer accused of misclassifying workers may be required to pay up to 3% of the employee’s salary, 100% of the Social Security and Medicare taxes, and 40% of the amount they should have withheld from the employee’s salary. The fines may go up to $50 for every W-2 Form they missed filing.

2. Federal penalties

   These are fines that an employer will have to pay for violating misclassified employees’ rights under federal laws. These too, depend on specific jurisdictions. Sometimes, the authorities may take intention into account – with inadvertent errors carrying less severe penalties compared to cases of willful misclassification.

   In the US, this can involve over a $1000 fine for every misclassified employee, in addition to insurance and benefit repayments. Other claims, punitive damages and attorney fees may be added to these. In extreme cases, it might even involve jail time!

3. Reputation related fallouts

   Misclassification cases may cause irreparable damage to a company’s reputation, with existing clients terminating contracts, and potential new clients taking their business elsewhere. The employer may also have trouble attracting and retaining talent, with employees being wary of their association with the company.

Checklist to determine the difference between contractors and employees

It is imperative to keep classification at the top of your mind, both while hiring employees as well as engaging contractors. Here’s a handy checklist to get you started.

• Review local laws

  Take the time to understand the rights afforded to an employee as well as a contractor, in your geography. This understanding will guide all your engagements going forward. Local laws differ everywhere, so it’s important not to make assumptions.

• Review roles and responsibilities 

  Understand the scope of the role you are looking to hire for, and create a comprehensive job description. This will help determine whether you need to hire an employee or engage a contractor.

• Establish clear contacts

  If you are hiring an employee, do so through an employment contract that adheres to all local labor laws. Ensure that it clearly outlines all the benefits and perks they are entitled to.

  When bringing contractors on board, draw up a comprehensive contract that outlines responsibilities, sets clear targets, states a specific project deadline, and establishes payment terms and milestones.
  
  In both cases, ensure that you uphold all the rights of that worker. For example, don’t put in an exclusivity clause in a contractor’s agreement, or try to assert undue control. Similarly, don’t ask employees to forgo rights like paid leave or sick days, either contractually or in practice.

• Gather the right information and fill the right forms

  The specific forms and documentation protocols differ based on location, so ensure you understand exactly what paperwork you need to get in order.
  
  As an employer in the US, you will need to file a W-2 tax form for each employee. For contractors, you will need to gather their information through Form W-9 or W-8BEN if they are based in another country. Thereafter, you will need to record payments above $600 through Form 1099.

  Here's some more information on the differences between a W-2 Employee and a 1099 Contractor.

• Maintain ongoing compliance

  Labor laws are often updated based on new legislations and changes in workers’ rights, so ensure you stay in the know and comply with these changes. For example, you may be required to update your employees’ minimum wages, honor new rules with regard to benefits and perks and so on.
  
  Do also review your contractors’ responsibilities periodically to ensure that the scope of work has not changed drastically from the time the contract was signed. If they are working on any new responsibilities or extra functions, update their contract to reflect this (while making sure that those responsibilities don’t blur the boundaries between contractors and employees!).

• Maintain separate payment protocols

  Maintain an organized payroll system for your employees. This will help you pay their salaries on time, deduct necessary taxes, and distribute bonuses and incentives. You may also be able to handle expense reimbursements through this system.

  For non-payroll workers, opt for a contractor and freelancer payment portal that has the capabilities to manage every aspect of their payments. A good payment portal should be able to process invoices, make payments, handle international charges and exchange rates, and maintain payments records for audits.

While the checklist is quite comprehensive, it is by no means exhaustive. Take our worker classification quiz for a more detailed guide that takes your specific circumstances into account.

How to avoid common mistakes when classifying workers

1. Make sure you are correctly designating salary vs hourly wages and the implications for overtime pay

You must first identify the employee's work responsibilities and any relevant labor rules in order to properly designate salary vs. hourly rates. Classify any employees who are entitled to overtime compensation as hourly workers and make sure they are paid for any hours worked above the typical workweek. Identify those who are exempt from overtime requirements as contract workers and confirm they satisfy the requirements outlined by labor legislation.

2. Correctly define different working schedules / patterns as full-time or part-time

Employees usually have set working hours and job locations as part of their contract with an employer. They could work full-time (30-40 hours) or fewer hours on a part-time contract. Independent contractors usually have much more flexibility in how they work. They set their own hours and work on tasks on a contractual basis with no particular daily or weekly schedule given to them.

3. Does your company have the right to direct or control how a worker does their work?

If your worker is an employee you will have more control over their work hours, where they work and how projects and tasks are performed. Independent contractors will have more autonomy as they dictate their own schedules and use their own tools and methods. This distinction is important as it helps determine classifications such as tax withholding and benefits and if done incorrectly, can lead to legal consequences. 

4. Who pays for business expenses as part of the work the worker is engaged in?

When it comes to employees, the employer tends to cover business expenses for them including equipment, office space and travel expenses as well as benefits like pensions and health insurance. On the other hand, independent contractors are usually responsible for covering their own expenses and need to take responsibility for their own taxes. It’s important to outline expense details within any contracts with independent contractors so that you can ensure tax and legal compliance.

Making worker classification seamless 

At first glance, the classification process may seem complex and daunting. However, with a good Agent of Record (AOR), you can reduce and mitigate compliance risk and admin.

We can help you by functioning as your Agent of Record (AOR), taking over the administrative aspects of working with contractors, crafting customized hiring and onboarding processes that work for you, and guiding you on classification protocols, even as labor and tax laws change. We also help you minimize the risks of misclassification by ensuring ongoing compliance from onboarding to timely payments and by acting as an intermediary between you and your contractors.

For more information on Agent of Record (AOR) vs Employer of Record (EOR), check out our blog.

Please note that this blog is simply a guide in helping you determine whether or not you should classify your workforce as employees or as contractors. We always suggest that every case is looked at by legal experts and worker classification should ultimately be decided by the employer.