Note: For comprehensive legal advice, see an attorney. This article seeks to offer general guidance and doesn't aim to give professional legal counsel to businesses or employees.

Understanding the legal and tax differences between independent contractors and employees is crucial to running a successful business. Many times, business leaders classify their labor force incorrectly. In this article, we’ll explore how to determine the designation between contractor and employee and discuss the criteria for each designation.

Should I hire a new individual as an independent contractor or employee?

This question isn’t up to personal preference, and it isn’t solely a tax question. However, many hiring managers only consider tax implications when deciding if a new worker should be an independent contractor or employee. This line of thinking is dangerous. The designation between employee or independent contractor has both legal and tax ramifications. 

The business world uses several tests to determine whether an individual should be designated as an employee or an independent contractor. These tests pose a series of questions to determine the amount of control an organization exerts on an individual. The main goal of each test is to determine if an organization controls both the manner and means of the individual. 

• The “manner” refers to the way an individual is to perform some task. For example, a manager directing each step of the process required to complete a job is deemed to be controlling the manner of the individual performing the work. Oftentimes a good rule of thumb is to use the “hours” test. If an employer directs the hours in which the individual should work, the individual will usually be classified as an independent contractor. 

• The “means” refers to the way an individual interacts with the organization. For example, an organization dictating when and where an individual is to be working is often deemed to be controlling their means.

When both the manner and means of an individual are controlled by an organization, the individual is typically considered an employee under the law. If the elements are not met, they may be considered an independent contractor. 

It is important to note courts have often upheld the precedent that both independent contractor and employee status should be an option for employers hiring for specific tasks. This has often meant that a level of leniency has been granted in fields such as acting even if the manner and means test is met. If there is no way to accomplish a task other than by controlling the manner and means of an individual, an organization may still be able classify that individual as an independent contractor.

Ultimately the determination of this legal classification is a complicated one. However, business leaders must realize that any decision made regarding how to classify their labor force must be done based on the level of control they intend to exercise. It is not good enough for an individual just to sign a contract or agree to be taxed a certain way. 

The Legal Differences

At Nimbl, we are authorized to counsel clients on tax and accounting matters. For a full discussion on legal differences, please contact your lawyer. However, we will give a brief overview of the legal differences so you can know what questions to ask.

Perhaps the biggest difference between employees and independent contractors is that employers can be held vicariously liable for employees’ actions while they cannot be for an independent contractor’s. This means that if an employee commits a tort or negligent act during work hours or while acting in the capacity of an employee, a company may be held liable to a third party for that employee’s actions.

Another difference involves the duties of the individual performing the labor. Under agency law, an employee is under a duty not to compete with their current employer. This means that employees within service firms cannot go out and start their own practice on the side – because they would be forming direct competition for their employer. Unlike employees, independent contractors are not under the same duty not to compete. Contractors often concurrently work jobs for multiple firms within the same industry. 

The Tax Differences

The tax difference between employees and independent contractors are quite simple. 

• Employees: An organization is required to withhold federal and state income tax, Social Security, and Medicare from wages paid. Both the organization and the employee are required to pay 7.65% for Social Security and Medicare. Both of these contributions sum to 15.3% in total employment taxes. An organization is also required to withhold and file both federal and state unemployment taxes on behalf of their employees.

• Independent Contractors: An organization is not required to withhold taxes. Additionally, employment and labor laws do not apply to independent contractors. These individuals record all of their earnings as earnings from self-employment (or as business income, depending on structure). This means that they must pay both the employer and the employee’s portion of employment taxes – totaling 15.3%. While this classification provides significant tax savings for an organization, the independent contractor should realize that they are paying 7.65% more in employment taxes than their employee counterparts.

Determining the correct designation for a recently hired individual can be a difficult and complex process. It is crucial to remember that employee vs. independent contractor is a legal designation with both legal and tax consequences. Seeking professional help in this area is extremely important and can save your business an immense amount of time and money.