Employee vs. Independent Contractor: Differences You Need to Know

You're so happy you just got hired, but the person you're working for just called you a name: "independent contractor." What does that mean? What kind of a business relationship is that? Can you come to the company picnic? 

While an "independent contractor" is different from a standard employee, the exact definition of your role is not set in stone.

To prevent any unwanted surprises, it is essential to define the exact business relationship between you and your employer prior to beginning work.

What is an independent contractor?

We can look in three different places when answering this question. A sometimes difficult status to define, what makes an independent contractor has been outlined by common law principles, the Fair Labor Standards Act, and finally the decisions of some courts.

The IRS and many states have adopted common law principles to define an independent contractor. These rules focus primarily on the level of control an employer has over a service or product, meaning, whether or not the employer actually defines what is being done and how it will be accomplished.

Common law principles further define independent contractor status by method of compensation. If a person is on an employer's payroll and receives a steady paycheck, clearly that the person is an employee rather than an independent contractor.

Other considerations when identifying someone as an independent contractor may include:

• If the worker supplies his or her own equipment, materials and tools
• If all necessary materials are not supplied by the employer
• If the worker can be discharged at any time and can choose whether or not to come to work without fear of losing employment
• If the worker control the hours of employment 
• Whether the work is temporary or permanent

Again, the nature of the work will help define the relationship. When work is considered integral to the business, it is more likely that the person is an employee. On the other hand, work that is temporary and non integral may imply independent contractor status.

The economic realities test

In an attempt to interpret provisions of the Fair Labor Standards Act and discern between employee and independent contractor status, some courts and federal agencies have come up with the "economic realities test."

It looks at the dependence of the worker on the business for which he or she works. If a person gains a large portion of their salary from that business, chances are that person qualifies as an employee.

The test also factors in such things as level of skill, integral nature of the work, intent of the parties and payment of social security taxes and benefits.

Outside of the Fair Labor Standards Act, courts ask the following questions to determine work relationship in addition to both an economic and an agency test:

• What is the degree of control over work and who exercises that control?
• What is each party's level of loss in the relationship?
• Who has paid for materials, supplies and/or equipment?
• What type of skill is required for work?
• Is there a degree of permanence?
• Is the worker an integral part of the business?

The right to control test

These courts also use the "right to control" test. When the hiring party controls the way work is carried out and a product is delivered, the relationship between the parties is employer/employee.

If an employer does not have authority over how a party accomplishes his or her work but simply give requests an outline, the relationship between the parties is that of hiring party/independent contractor.

Employer tax liability

An employer's tax liability is determined by the worker's employment status. When a worker is an employee, employers must pay state and federal unemployment tax, social security tax and workers compensation/disability premiums to a State Insurance Fund.

When a worker is an independent contractor, the hiring party is not required to make any of these payments.

Should employers incorrectly define a worker as an independent contractor, they may find themselves liable for past taxes including FICA and federal unemployment tax.

Safe harbors which allow employers to use the independent contractor status and avoid penalties include: prior practice of treating similar employees as independent contractors and the existence of a prior IRS audit where no taxes were required to be paid.

The law is clear

Certain factors will define a worker as an independent contractor in every case: not relying on the business as the sole source of income, working at his or her pace as defined by an agreement, being ineligible for employer provided benefits and retaining a degree of control and independence.

While the independent contractor is his or her own boss, work stays within the definitions of oral or written contract and adheres to certain requirements.

An employee, on the other hand, relies on the business for steady income, gives up elements of control and independence, is eligible for certain benefits and works within constraint of workplace.