Independent Contractors vs. Employees and Why It Matters

October 1, 2020

Legal knowledge

We have been asked frequently how to distinguish an independent contractor from a company employee. Does it matter? From the company's perspective, it matters. The distinction between them is crucial because the company does not need to provide benefits such as health insurance and a retirement savings plan (also known as a 401k plan) for independent contractors, nor does the company need to pay state and federal payroll taxes (include social security, Medicare taxes, and unemployment compensation). Furthermore, independent contractors are much less regulated than regular employees, where the companies need to abide by multiple layers of rules and regulations regarding hiring and firing, vacation policy, etc.

The differences between independent contractors and salary-based employees are also reflected in the stock options of a startup company. An incentive stock option (“ISO”) is a corporate benefit that gives an employee the right to buy shares of company stock with the benefit of possible tax breaks on the profit. The profit on qualified ISOs is usually taxed at the capital gains rate (usually 15%-20%), not the higher rate for ordinary income (usually 37%). ISOs can only be granted to employees. 

On the other hand, Non-qualified stock options (“NSOs”) can be granted to any service provider (including both employees and independent contractors). NSOs are stock options that, when exercised, result in ordinary income (tax rate is usually 37%) taxable for the difference between the exercise price and the fair market value of the underlying shares and calculated on the exercise date. Public companies typically grant NSOs, as opposed to private companies, which it is common for them to grant ISOs. 

Given that misclassification can create serious legal problems, entrepreneurs should take great care when classifying workers. 

So what are the factors to distinguish salary-based employees from independent contractors? What makes someone an independent contractor vs. a salary-based employee? 

Internal Revenue Service 20-point checklist for Independent Contractors

The IRS has a laundry list of factors to consider. Their evaluation is focused on control, behavior, finances, and the type of relationship the two parties have. Generally, independent contractors retain sufficient control and autonomy with respect to the manner and means of their performance. On the contrary, workers subject to regular supervision and control are more likely to be considered employees. Here are twenty factors used by the IRS as a guide to determine whether the entities paying for services have enough control over the person providing the services.

1. Profit or loss 

Independent contractors are responsible for their own business’s profit or loss, while employees are not. 

2. Investment 

If a worker has an investment in the equipment used to perform the work, he is likely to be an independent contractor. Otherwise, the worker is likely to be an employee. 

3. Works for more than one firm 

Independent contractors can work on multiple projects for different firms, while employees can only work for one firm. 

4. Services offered to the general public 

An independent contractor offers services to the general public through advertising, while an employee does not. 

5. Instructions 

Independent contractors do not need to follow certain instructions to provide services, while employees need to follow specific instructions about when, where, and how to perform the work. 

6. Training 

Employees are usually provided with training, while independent contractors are not because they are already trained. 

7. Integration 

If a worker’s services are so essential to the business as part of it, he or she is likely to be an employee and is subject to the employer’s control. 

8. Services rendered personally 

If the tasks can be delegated to someone else and do not need to be rendered personally, the worker is likely to be an independent contractor. Otherwise, the worker is an employee. 

9. Hiring assistants 

Same as the analysis above. If a worker hires someone else to perform the work and pays his or her own staff, he or she is likely to be an independent contractor. Otherwise, the worker is an employee. 

10. Continuing relationship 

If services are performed frequently, but not regularly, the relationship can be considered ongoing and once the contract is over and the payment is made, an independent contractor owes no duties to the entity paying the services. 

11. Work hours 

Independent contractors have flexible work hours, but employees need to comply with the working schedule set by the employer. 

12. Full-time work 

Generally, independent contractors choose when and where they will work. On the contrary, employees usually do not have a choice.

13. Work done on-premises 

Independent contractors do not need to work on the premises; employees are subject to control over where the work will be performed. 

14. Sequence 

If the entity paying for the services has the right to determine the order in which services are performed, the worker is likely to be an independent contractor because this shows control over the worker. 

15. Reports

Independent contractors do not provide updates until the project is done; However, an employee gives his employer reports accounting for his actions. 

16. Pay Schedules 

Independent contractors get paid according to the agreed-upon terms and conditions of the contract; employees, on the other hand, get paid according to the payroll schedule (weekly, bi-weekly, or monthly). 

17. Expenses 

For independent contractors, expenses are part of the total payment for the services, while expenses are out-of-the-pocket costs for employees and can be reimbursed by the employer. 

18. Tools and materials 

Independent contractors are not provided with equipment, tools, or materials and usually use their own tools and equipment for the job.

19. Right to fire 

Given that there is a contract signed by the independent contractor and the entity receiving the services, independent contractors can not be fired without causing the risk of breach of contract; at-will employees can be terminated at any time for any reason. 

20. Worker’s right to quit 

Same as the analysis above. An independent contractor has a legal obligation to complete the contract pursuant to the terms and conditions of the contract; at-will employees can quit at any time for any reason as long as advance notices are given to the employer properly. 

What is the ABC test? 

The state of California has a famous "ABC" test, which focuses on whether the worker is free of the control of the hiring entity, whether the worker performs work outside of the hiring entity's usual business, and whether the worker has an independent business that's consistent with the work they are doing for the hiring entity. A worker is considered an employee and not an independent contractor unless the hiring entity meets all three conditions of the ABC test:

  1. The person is independent of the hiring organization in connection with the performance of the work, both under the contract for the performance of the work and in fact.
  2. The person performs work that is outside the hiring entity’s business.
  3. The person is routinely doing work in an independently established trade, occupation, or business that is the same as the work being requested and performed.

In addition, a worker’s status can affect the employer's rights to any copyrightable works or patentable inventions created by the worker. We will write a separate article about this topic and discuss these issues thoroughly (stay tuned!) 

In a nutshell, the employer generally is deemed to be the author of any work created by an employee acting within the scope of employment. Similarly, the employer is the owner of any invention created by an employee. In contrast, a company commissioning work by an independent contractor will not own the copyright unless the company secures either a written contract stating that it is “a work made for hire” or a written assignment of the copyright.

There are lots of good resources, diagrams, and checklists about this topic.

*The information provided on this website does not, and is not intended to, constitute legal advice; instead, all information, content, and materials available on this site are for general informational purposes only.

Independent Contractors vs. Employees and Why It Matters Infographic