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Employees versus Independent Contractors

The Definitions, Differences, and Documents

Last Updated: April 16, 2024

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Kristen Thomas
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Key Takeaways:

  • Employees and independent contractors have distinct roles, responsibilities, and obligations to businesses and clients.
  • Employees work for wages, receive benefits, and follow a set schedule, while independent contractors are self-employed, set their own hours, and negotiate rates.
  • Choosing the right contract is crucial to defining expectations and responsibilities.

Employees, independent contractors...you might be asking yourself: what is the difference, really? On paper, these workers do similar things: provide services to a business in exchange for payment.
But beware: confusing employees and independent contractors can be a costly mistake.
Incorrectly labeling an employee as an independent contractor is known as worker misclassification, which can have negative consequences for both the individual and the business.
To protect yourself or your company from the risks of misclassification, let’s break down the differences between independent contractors and employees. In this article, we’ll outline the key factors that distinguish these two categories of workers. Plus, read more about four essential documents any business or worker needs to ensure their working relationship is crystal clear and free from risk.

What are the risks of worker misclassification?

In 2023, the Economic Policy Institute published a study about the financial costs of incorrectly labeling an employee as an independent contractor, also known as worker misclassification.
They found that, when employees are misclassified as independent contractors, they are denied access to crucial labor and economic rights, such as the right to minimum wage or overtime pay. As a result, the Economic Policy Institute reports that misclassified workers could lose up to $18,000 per year.
And the consequences of misclassification for employers aren’t cheap either. Under the Fair Labor Standards Act, employers may be responsible for financially compensating the misclassified employee for missed wages, benefits, or tax amounts. Additionally, they could face costly penalties from both federal and state departments.

What is an employee?

An employee is someone who works for a business in exchange for a specific wage or salary.
Generally speaking, employees:
  • Work for one company
  • Are given training by their employer
  • Have a set work schedule
  • Work at the direction of their employer
  • Do not have to provide tools or a workspace
  • Are provided with company benefits
Additionally, employees are subject to the following regulations and laws:
  1. Labor laws: Employees are provided with certain rights, like minimum wage, under the Fair Labor Standards Act. They are also protected under state labor laws.
  2. Tax regulations: Employers are responsible for deducting taxes from an employee's paycheck. They will then provide the employee with a W-2 form on a yearly basis.

What is an independent contractor?

An independent contractor is someone who works for themselves and provides services to clients. Usually, independent contractors are freelancers with specialized skills. Some of the most common types of independent contractors include construction workers, freelance writers, developers, designers, and consultants.
Typically, independent contractors:
  • Work for multiple companies or clients
  • Are not trained on a company’s policies and procedures
  • Set their own work schedule
  • Work on their own, based on a general request from the client
  • Provide their own equipment and workspace
  • Can register for benefits as self-employed
To secure independent contractor positions effectively, having a well-crafted resume showcasing skills and experience is essential. Plus, being able to tailor the job description to match the requirements of each client can greatly enhance the chances of landing contracts.
When it comes to tax regulations and labor laws for independent contractors, here are a couple of things to keep in mind:
  1. Labor laws: Independent contractors are not considered employees under the Fair Labor Standards Act. This means they are not covered by the wage and work-hour regulations set forth in this act.
  2. Tax regulations: Clients do not deduct taxes from a freelancer’s payment. Instead, the independent contractor is responsible for ensuring the proper tax amount is paid. Usually, a client provides the contractor with a Form 1099 if they have paid the contractor $600 or more during the tax year.

What are the differences between employees and independent contractors?

It is important to have a clear understanding of the distinction between independent contractors and employees in order to avoid worker misclassification. Let’s break it down.
The key differences between an employee and an independent contractor are:
Employee Independent Contractor
Hiring documents When hired, the employer provides the employee with an Employment Contract. When contracted for services, an independent contractor and client enter into an Independent Contractor Agreement or a Service Agreement.
Regulations Federal labor laws protect employees, specifically the Fair Labor Standards Act, in addition to any state-specific regulations.

Independent contractors are not covered by the Fair Labor Standards Act.

Independent contractor status is determined through a series of federal and state-specific tests, such as the ABC, common law, or economic reality tests.
Taxation & tax forms Employers deduct taxes. At the end of the year, the employer provides the employee with a Form W-2.

Clients typically do not deduct taxes.

Clients must provide the contractor with a Form 1099 for any payments of $600 or more.

Benefits Employees are usually a part of the corporation's benefits programs, such as health insurance or stock options.

Contractors are not eligible for client benefit programs.

They are responsible for independently enrolling in health insurance and other programs.

Employment flexibility Employees are governed by the policies and regulations laid out in the company's Employee Handbook. Independent contractors set their own employment terms, including working hours, time off, and payment rates.
Payment

Employees earn a salary and get paid according to the company's payment structure (weekly, bi-weekly, monthly, etc.).

 It is up to the client and the contractors to decide how they will handle payment. Usually, the contractor sets their rates.
Termination documents For employees, use an Employment Termination Letter. For independent contractors, use a Termination Agreement.

Can an employee also be an independent contractor?

Technically yes, an employee can also be an independent contractor. A person with a full-time job can also provide freelance services to other businesses as an independent contractor.
Additionally, the IRS states that a worker can be both an independent contractor and an employee for the same company if they serve separate and distinct services in both roles. For example, a person could work as an administrative clerk for a company while also offering after-hours cleaning services to the company on a contract basis. In this case, the company would be responsible for providing both a Form W-2 and a Form 1099 to this worker.

What factors distinguish an employee from an independent contractor?

As we’ve already mentioned, clearly distinguishing between an employee and an independent contractor is extremely important and helps to avoid worker misclassification.
Here’s something to keep in mind: simply stating that an individual is an independent contractor or using an Independent Contractor Agreement does not mean this worker is automatically an independent contractor in the eyes of the law. Instead, the worker must meet the relevant state and federal criteria set out in an independent contractor classification test.
In order to legally determine the difference between an employee and an independent contractor, there’s several state and federal tests you can use. Federally, you can use the economic reality test, which took effect in March 2024. Additionally, some states use the ABC test or the common law test.
Let’s take a closer look at these three tests.

Economic Reality Test

In January 2024, the U.S. Department of Labor released a final rule to help clearly identify the difference between employees and independent contractors.
This legislation reaffirms the importance of an economic reality test, which helps determine if a worker is economically dependent on the employer for work. In other words, this test helps determine if an employer-employee relationship exists.
The new economic reality test is comprised of the following factors:
  • Opportunity for profit or loss depending on managerial skill
  • Investments by the worker and the employer
  • Permanence of the work relationship
  • Nature and degree of control
  • Whether the work performed is integral to the employer’s business
  • Skill and initiative
For more information about how these factors work, visit the U.S. Department of Labor website.
Additionally, if you have further questions or concerns about employees and independent contractors under the new economic reality test, it might be helpful to speak with a lawyer.

ABC Test

In some states, such as California, the ABC test helps decide if someone is an employee or an independent contractor. It’s commonly used to figure out state unemployment tax eligibility. To be considered an independent contractor by this test, the following must be true:
  • A: The worker can complete work free from the employer’s control or direction.
  • B: The work is outside the usual course of the client’s business or the work primarily occurs off the site of the business.
  • C: The worker is engaged in an independent trade, occupation, profession, or business.
Some states, like California and Illinois require an individual to fulfill all three of the criteria in order to be classified as an independent contractor. Other states, like Colorado, require workers to only fulfill two of the three.

Common Law Test

The final test that you can use to properly classify workers is the common law test. Much like the ABC test, this test is primarily used for tax purposes.
There are three factors to the common law test:
  • Behavioral facts, which show whether a company has the right to control how a worker does their job
  • Financial control, otherwise known as if there are economic aspects of a job that an employer controls
  • The type of relationship the worker and business have with each other
The common law test may also be called the “right-to-control test” or the IRS 20-factor test.
For more information about these three factors, please consult the IRS website.

Independent Contractor Tests by State

Although all companies are subject to the federal regulations set by the U.S. Department of Labor, they may also need to comply with state-specific requirements. Specific states may use either the ABC test or the common law test. Here’s a full breakdown of which state uses which test:
Map that breaks down which state uses which independent contractor test

When should I hire an independent contractor versus an employee?

Both independent contractors and employees can add significant value to a business, just in different ways.
On the one hand, hiring an employee is a crucial step in expanding your business. They can help alleviate your workload and take care of day-to-day tasks, leaving owners free to manage the higher-level operations of their business. Generally, hiring an employee is seen as a long-term investment.
In other instances, outsourcing work to independent contractors is a cost-effective strategy to boost productivity and profits. Working with an independent contractor is usually a good solution for companies that are looking for short-term work on specialized projects.
No matter what type of worker you choose to hire, it's important to use proper documentation that clearly outlines the terms and conditions of this working relationship. That’s where Employment Contracts and Independent Contractor Agreements come in.

If hiring an employee, use an Employment Contract

An Employment Contract sets out employment terms, conditions, and expectations between an employer and employee.
Employment Contracts include the following terms:
  • The type and rate of compensation
  • The frequency of payment
  • Vacation time
  • Specified work hours and work location
  • Employee responsibilities
  • Length of a probationary period
  • Confidentiality, non-solicitation, or non-competition clauses
  • Termination terms
Employees typically sign an Employment Contract after receiving an Employment Offer Letter from a business’s human resources department.

If hiring an independent contractor, use an Independent Contractor Agreement

An Independent Contractor Agreement is a written contract that spells out the terms of a working relationship between a contractor and a client. This document creates evidence that a contract between the parties exists.
Independent Contractor Agreements include the following terms:
  • Details about the type of service the contractor will provide
  • Both the contractor’s and the client’s details
  • Duration of the services
  • Payment details, including how the contractor gets paid and the frequency of payment
  • Retainer details
  • Termination terms
  • Confidentiality and intellectual property clauses
After negotiating the terms of their working relationship, either party can provide an Independent Contractor Agreement. This is useful because it establishes a written contract, which is more secure than a verbal agreement. In case of any confusion or conflict, both the client and the contractor have a document to reference.
Independent contractors can also use a general Service Agreement. Plus, LawDepot offers custom templates for specific professions, such as catering, cleaning, and computer services.

How do I terminate work agreements with independent contractors versus employees?

Unfortunately, sometimes a professional relationship doesn’t work out. Whether you are terminating an employment contract or letting go of a freelancer, here’s how to proceed.

If firing an employee, use an Employment Termination Letter

Dismissing an employee is a difficult situation that most small business owners will have to face at some point. Although this is a tough task, you can simplify the process by using an Employment Termination Letter.
An Employment Termination Letter usually includes:
  • A description of the event(s) that led to the employee dismissal
  • Any expenses owed to the employee
  • The employee’s termination date
  • Any details about severance pay or vacation payout (if applicable)
Generally, an employee’s termination is subject only to the private contract between the employee and employer. However, in some cases, Equal Employment Opportunity laws prohibit specific types of employment discrimination. Consult the U.S. Department of Labor’s website for further details and to ensure you are legally compliant.

If firing a freelancer, use a Termination Agreement

When it comes time to end a working relationship with an independent contractor or freelancer, you can do it clearly, efficiently, and professionally by using a Termination Agreement.
A Termination Agreement is a legal document that two parties use to mutually cancel a contract.
A Termination Agreement includes:
  • Details about the original contract
  • The termination date of the contract
  • Any final compensation details, if necessary
Using this document is beneficial because it allows both parties to walk away knowing that the other party has released them of their obligations.

Avoid misclassification. Get it in writing.

Although both employees and independent contractors can add significant value to your business, it is in your best interest to clearly understand the difference between them.
In addition to protecting you or your business from employee misclassification, understanding the definitions and duties of both employees and independent contractors can help establish a clear working relationship from the get-go. With proper documentation, both parties are legally protected in case of a future misunderstanding or dispute.
Finally, remember: just because two parties sign an Independent Contractor Agreement, this doesn’t mean the worker is automatically an independent contractor. Instead, this individual must meet the relevant criteria outlined in either an economic reality, ABC, or common law test.
Now that you’ve mastered the difference between independent contractors and employees, along with the applicable laws and documentation, navigating the modern workforce will be smooth sailing. Good luck!