Individuals hired by business owners to work their business can either be classified as an independent contractor or employee. Sometimes the distinction between the two is not clear and can get very blurry, but knowing the difference is imperative.

It is important to be able to recognize the differences between independent contractors and employees to ensure you, the business owner, pay the proper taxes and avoid potential legal issues.

Independent contractors typically work under their own business name conducting business on their own terms. Employees, on the other hand, perform duties under the control of an employer.

Although the definition isn’t clear and the list is not exhaustive, there are some factors that are considered by the courts when determining whether an individual is an independent contractor:

1. Whether the individual provides his or her own materials, equipment and/or supplies
2. Whether the individual may be discharged anytime and choose whether or not they return, and
3. Who controls the hours of employment

The Supreme Court considers the following factors to determine if an individual is an employee:

1. The degree of control an employer has over the individual
2. The degree of control an employer has over the individual’s work
3. Which individual provided the materials, equipment and/or supplies
4. The skill type required for the work, and
5. Whether or not the individual is an integral part of the business. 

Although determining the clear distinction can get complicated, considering the following factors to help decide your hiring move.

Taxes

An individual’s employment status determines an employer’s tax liability. Employers must provide employees with workers compensation and disability premiums and must pay both federal and state unemployment taxes.

An employee is responsible to pay taxes on Social Security, Medicare and FICA. An independent contractor on the other hand, must pay the higher self-employment tax and their increased income leads to paying higher employment taxes as well. 

Independent contractors may however write off all “reasonable and necessary” expenses associated with the ordinary operation of the business when doing their taxes. Employees on the other hand, may only write off a limited amount of non reimbursed expenses associated with their business.

Liability

The doctrine of Respondeat Superior is a legal doctrine most commonly used in tort law. It holds employers legally liable for the wrongful acts of their employees that occur “within the scope of the employment.”

For example, if an employee painting a house accidentally spills paint on an expensive sculpture, the employer will be held responsible to pay any and all damages associated with the spilled paint.

Generally, employers will not be held liable for the negligence of an independent contractor. The independent contractor himself  will be held responsible for any and all injuries arising from his or her conduct. It is important to note that there are some exceptions that apply in different states. 

California, for example, follows the “peculiar risk doctrine” which only holds employers liable for injuries or damages caused by their independent contractors if:

1. An employer hired an independent contractor to perform “inherently dangerous work” and failed to specify regulations and/or safety precautions; or
2. An employer hired an independent contractor to perform “inherently dangerous work” and specified regulations and/or safety precautions but the independent contractor ignored the regulations and caused an injury and/or damage that could have been avoided had the regulations been observed. 

The policy behind this doctrine is to ensure that employers engaged in dangerous activities cannot avoid all liability by hiring independent contractors. Rather, employers must ensure safety by not only implementing precautions and regulations, but by enforcing them as well.

Furthermore, employers are not required to provide worker’s compensation insurance for independent contractors. However, employers are required by state law to provide worker’s compensation insurance for their employees.

Benefits

Employees have better benefits such as subsidized health insurance, life insurance and disability insurance. Furthermore, employees may be able to collect retirement pensions once their employment is terminated. Employees also have the possibility of receiving bonuses.

Independent contractors do not enjoy these same benefits offered exclusively to employees.

Financial Responsibility

Independent contractors will face more expenses associated with starting-up and running their business. These fees include the cost of creating their business entity, overhead expenses, hiring staff if necessary and purchasing tools and materials.

Employees will only be responsible for ordinary costs associated with their profession including the cost of commuting and purchasing appropriate clothes. Depending on the circumstances, some employee expenses can be reimbursed by employers.

Intellectual Property Rights

Intellectual property rights are the ownership rights of an individual over a creative work. Trademarks, copyrights and patents are the most common types of intellectual property.

An employee does not retain ownership rights of the intellectual property he or she creates in the scope of his or her employment. Per a written agreement, the employee will likely have to assign the intellectual property to his or her employer.

Meaning, if you create a cool slogan, nice design or make an invention during your employment (while in the office), your employer has a right to that. 

An independent contractor will generally retain the rights to his or her intellectual property unless the works were specifically commissioned and there is a written agreement transferring ownership.

Social Aspects

Employees are surrounded by co-workers who they can bounce ideas off of or collaborate and create great work products with. Employees are also motivated to work harder by their surrounding co-workers, affirmation by their employers and potential bonuses dangling over their heads. 

Independent contractors on the other hand, must be self-motivated. They must rely on personal goals to ensure productive work. These goals can include creating a better portfolio or reputation for themselves that allows growth and future opportunities.

Conclusion 

It is very important that employers correctly classify individuals as employees or independent contractors. If done so incorrectly, employers may be found liable for retroactive FICA, Medicare and Social Security taxes. They may also be required to pay back taxes, provide employee benefits, worker’s compensation and unemployment.

In some cases, employers may also face both civil and criminal penalties as a result of their misclassification and even be ordered to pay attorney fees.

Topics: Business Tips, Copyright, Intellectual Property, IRS, Small Business, Startups, Tax