Independent contractors and employees are not the same, and it's important to understand the difference. This distinction will affect how you withhold a variety of taxes, and misclassification of an individual may result in a number of costly legal consequences.

What’s the Difference?

An Independent Contractor:

• Operates under a business name

• Has his/her own employees

• Maintains a separate business checking account

• Advertises his/her business' services

• Invoices for work done

• Has more than one client

• Has own tools and sets own hours

• Keeps business records

An Employee:

• Performs duties dictated or controlled by others

• Is given training for work to be done

• Works for only one employer

Many small businesses rely on independent contractors for their staffing needs. There are many benefits to using contractors over hiring employees:

• Savings in labor costs

• Reduced liability

• Flexibility in hiring and firing

Why Does It Matter?

The distinction between employee and independent contractor is important, since it affects how you withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment taxes. In addition, misclassification of an individual as an independent contractor may have a number of costly legal consequences.

However, in legal terms, the line between an independent contractor and an employee is not always clear. Your workers are not independent contractors because you say they are.

If your independent contractor is discovered to meet the legal definition of an employee, you may be required to:

• Reimburse them for wages you should've paid them under the Fair Labor Standards Act, including overtime and minimum wage

• Pay back taxes and penalties for federal and state income taxes, Social Security, Medicare and unemployment

• Pay any misclassified injured employees workers' compensation benefits

• Provide employee benefits, including health insurance, retirement, etc.

Tax Requirements

• Independent Contractor or Employee?

Provides an IRS guide that explains how to determine if your workers are independent contractors or employees for federal tax purposes.

• Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding

Enables business owners to file Form SS-8 with the IRS to request a determination of the status of a worker for purposes of federal employment taxes and income tax withholding.

Employment Information

The Supreme Court has claimed there is no single test for determining if an individual is an independent contractor or an employee according to the Fair Labor Standards Act. However, the following guidelines should be taken into account for determining whether the work being done is by an independent contractor employee or an employee based on the situation presented.

1. The extent to which the services rendered are an integral part of the principal's business.

2. The permanency of the relationship.

3. The amount of the alleged contractor's investment in facilities and equipment.

4. The nature and degree of control by the principal.

5. The alleged contractor's opportunities for profit and loss.

6. The amount of initiative, judgment, or foresight in open market competition with others that is required for the success of the claimed independent contractor.

7. The degree of independent business organization and operation.

Whether a person is an independent contractor or an employee generally depends on the amount of control exercised by the employer over the work being done. Spelling out and describing how a job is to be done or limiting the actions of the worker may establish an employer-employee relationship. Read the compliance manual, Equal Employment Opportunity Laws - Who's Covered? for more information on how to determine whether a person is an independent contractor or an employee, and which are covered under federal equal employment opportunity laws.