Cecily Zamora
The distinction between an employee and an independent contractor is often blurry, and it is critical that business owners correctly determine whether individuals providing services are employees or independent contractors. This distinction is important because it determines who is responsible for federal withholdings and tax obligations. Under common law, a worker is an employee if the employer has the right to direct or control the worker, both as to the final results and as to the details of when, where, and how the work is done. However, the right to control need not be exercised, and the worker may still be an employee if the employer has the legal right to control. The ABC test, on the other hand, assumes that all workers are employees and places the burden on the hiring entity to prove that the worker is an independent contractor by satisfying certain conditions. Other factors that may be considered include the opportunity for profit or loss, skill and initiative, and whether the worker is in business for themselves or is economically dependent on the employer.
| Characteristics | Values |
|---|---|
| Nature of work | The work performed by an independent contractor is usually separate from the client's business and is not integrated or merged into it. |
| Control | An independent contractor has a lot of control over how they perform their jobs. |
| Work instructions | An independent contractor does the job their own way with few, if any, instructions as to the details or methods of the work. |
| Training | An independent contractor uses their own methods and does not receive training from the client. |
| Work timings and location | An independent contractor is free from the control and direction of the client in connection with the performance of the work. |
| Hiring assistants | An independent contractor hires their own assistants. |
| Tools and equipment | An independent contractor is responsible for obtaining and maintaining the tools they need to do their work. |
| Profit and loss | An independent contractor's profit and loss balance sheet is largely under their purview. |
| Business expenses | An independent contractor includes their business-related expenses on their job bid and agreement. |
| Taxes | Independent contractors are generally not subject to self-employment tax. |
| Benefits | An independent contractor does not receive employee benefits, sick time, and vacation pay. |
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What You'll Learn
Common law test
The common law test is used to determine whether a worker is an employee or an independent contractor. This distinction is critical as it determines the worker's rights and the employer's responsibilities.
The common law test examines the relationship between the worker and the company they provide services to. It considers three categories: behavioural, financial, and relationship.
Behavioural factors include the degree of control the company has over the worker. For example, an independent contractor decides how to perform their job, while an employee is given detailed instructions and oversight. An independent contractor also has the freedom to work for multiple companies and is not restricted from working in other occupations or businesses.
Financial factors include the worker's opportunity for profit or loss and their ability to negotiate pay, hire their own workers, and purchase equipment. Independent contractors are typically responsible for obtaining and maintaining their own tools and equipment, and they bear the costs of business-related expenses.
Relationship factors include the permanence of the work arrangement, the integration of the worker's services into the company's operations, and whether the worker is essential to the company's success or day-to-day business.
It is important to note that no single factor determines whether a worker is an employee or an independent contractor. The determination is made by considering all relevant factors and the entire relationship between the worker and the company.
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ABC test
The ABC test is used by employers to determine whether a worker is classified as an employee or an independent contractor by federal and state governments. The test is particularly relevant as more workers are moving towards the gig economy. The ABC test assumes that all workers are employees 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.
- The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.
Prong B of the ABC test, as explained by the California Supreme Court in Dynamex, states that contracted workers who provide services in a role comparable to that of existing employees will likely be viewed as working in the usual course of the hiring entity's business. For example, when a clothing manufacturing company hires work-at-home seamstresses to make dresses from cloth and patterns supplied by the company, the work is part of the company's usual course of business. Conversely, when a retail store hires an outside plumber or electrician, the work is not part of the usual course of business.
Prong C of the ABC test was also explained by the California Supreme Court in Dynamex, which stated that the hiring entity must prove the independent business operation is actually in existence at the time the work is performed. The worker must be engaged in an independently established trade, occupation, or business of the same nature as the work performed for the hiring entity. For example, if a worker normally performs the same duties for other clients, they could be considered an independent contractor.
The ABC test is designed to make it easier for businesses and workers to determine whether a worker is an independent contractor or an employee. It is important for business owners to correctly determine whether individuals providing services are employees or independent contractors, as this distinction impacts workers' compensation benefits, income taxes, and Social Security and Medicare taxes.
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Employee benefits
An independent contractor is a worker who is in business for themselves and is not an employee of the company they are providing services to. The distinction between an employee and an independent contractor is important, as misclassification can lead to serious consequences for the company, including liability for employment taxes, back wages, and insurance claims.
The IRS uses an 11-factor test to determine whether a worker is an independent contractor or an employee, based on the company's ability to direct and control the worker. Some of the factors include:
- The company's control over what the worker does and how they do their job.
- Whether the business controls the financial aspects of the worker's job, such as payment methods, reimbursement of expenses, and provision of tools or supplies.
- The type of relationship between the company and the worker, including the existence of written contracts, employee benefits, and the expected duration of the relationship.
Now, onto the employee benefits of being an independent contractor:
Higher Earnings
Independent contractors tend to earn more than employees in the same business position, up to 40% more. This is because companies do not need to pay social security tax, provide employee benefits, or supply equipment for contractors. Contractors can, therefore, request higher rates for their services.
Flexibility and Independence
As an independent contractor, you are your own boss and have greater flexibility and independence in how you work. You can negotiate your pay, decide whether to accept or decline work, hire your own workers, and manage your own time.
Tax Benefits
While independent contractors may pay more in taxes, they can also benefit from tax advantages. For example, in the US, independent contractors can file as a sole proprietorship, which allows them to deduct business expenses and take advantage of tax credits and deductions not available to employees.
Limited Liability
As an independent contractor, you may have limited liability for the company you are providing services to. This means that you may not be held responsible for the company's debts or liabilities, although this can vary depending on the specific contract and local laws.
Skill Development and Variety
Independent contractors often work with multiple clients or companies, which can provide opportunities to develop new skills, gain diverse experiences, and build a broader professional network.
However, it is important to note that there are also potential drawbacks to being an independent contractor, including uncertain income, lack of traditional employee benefits like health insurance and retirement plans, additional administrative responsibilities, and limited job security.
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Tax obligations
The distinction between an independent contractor and an employee is important for tax purposes. Generally, businesses withhold and deposit income taxes, Social Security taxes, and Medicare taxes from the wages paid to an employee. Additionally, businesses must also pay the matching employer portion of Social Security and Medicare taxes, as well as unemployment tax on wages paid to an employee. On the other hand, businesses generally do not have to withhold or pay any taxes on payments to independent contractors.
Independent contractors are typically considered self-employed and are therefore responsible for paying self-employment taxes, which cover Social Security and Medicare taxes. They must also make quarterly estimated tax payments to the IRS, which include income tax and self-employment tax. These estimated tax payments are made if the tax liability is expected to be $1000 or more for the year after accounting for withholding and credits.
It is critical for businesses to correctly classify their workers as either employees or independent contractors. Misclassifying workers can result in increased taxes, penalties, and interest for the business. To determine whether a worker is an employee or an independent contractor, the IRS and state agencies consider various factors, including the degree of control and independence in the working relationship.
The ABC test, used in some states, assumes that all workers are employees unless the hiring entity can satisfy three conditions:
- The worker is free from the control and direction of the hiring entity in connection with the performance of the work.
- The worker performs work that is outside the usual course of the hiring entity's business.
- The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed.
Other factors that may be considered include the opportunity for profit or loss depending on managerial skill, skill and initiative, and the economic realities of the working relationship. The place where the work is performed, whether the worker is licensed by the state or local government, and the time or mode of pay are generally not relevant in determining the worker's classification.
In summary, independent contractors have different tax obligations than employees, and it is important for businesses to correctly classify their workers to comply with tax requirements and avoid penalties. Independent contractors are typically responsible for their own tax payments and may be subject to self-employment taxes, while employees have taxes withheld from their wages by their employers.
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Worker rights
Rights of Employees
Employees have their taxes, Social Security, Medicare, and unemployment taxes withheld and deposited by their employer. They are also protected by the minimum wage and overtime pay requirements of the Fair Labor Standards Act (FLSA). Employees are often trained by a more senior employee and are required to attend meetings and training courses. They are typically given instructions about when, where, and how to perform their work. Employees do not usually hire their own substitutes or delegate work to others.
Rights of Independent Contractors
Independent contractors are generally considered self-employed and are responsible for their own taxes. They are not covered by the FLSA and are therefore not entitled to minimum wage or overtime pay. They have a lot of control over how they perform their jobs, and are free to use their own methods without receiving training from their clients. They are responsible for obtaining and maintaining their own equipment and can hire their own workers. They can also negotiate their pay, decide whether to accept or decline work, and engage in marketing or advertising.
Determining Worker Classification
The classification of a worker as an employee or independent contractor is not always clear-cut, and there are tests to help determine this. The ABC test assumes that all workers are employees unless the hiring entity can prove that the worker is:
- Free from the control and direction of the hiring entity in connection with the performance of the work.
- Performing work that is outside the usual course of the hiring entity's business.
- Customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.
The Common Law Test also considers the degree of control and independence of the worker, examining whether the employer has the right to direct or control the worker and the final results, as well as when, where, and how the work is done. Other factors include whether the worker is penalized for missing meetings, who hires any helpers, and whether the worker is essential to the success or day-to-day business of the company.
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Frequently asked questions
A common law independent contractor is a worker who is self-employed and in business for themselves. They are not considered an employee of the company they provide services to and are therefore not covered by the Fair Labor Standards Act (FLSA).
An independent contractor has a lot of control over how they perform their job and is responsible for obtaining and maintaining the tools they need to do their work. They are also in charge of their profit and loss balance sheet and can hire their own workers. On the other hand, an employee receives instructions about when, where, and how to perform their work and is often trained by a more experienced employee.
The line between independent contractors and employees can sometimes be blurry. Generally, if you are an independent contractor, you are responsible for obtaining and maintaining your own tools, managing your profit and loss balance sheet, and making business-related decisions. You should also be able to assign another person to do the job in your place. However, if your company is directing how you do your job, providing training, and giving detailed oversight, you may be an employee rather than an independent contractor.
Being an independent contractor or an employee has implications for taxes and benefits. Independent contractors are typically responsible for their own taxes and are not covered by the minimum wage and overtime pay requirements of the FLSA. Employees, on the other hand, have taxes withheld from their wages, including income taxes, Social Security taxes, and Medicare taxes. They may also receive employee benefits such as sick time and vacation pay.
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