Independent Contractor vs. Employee: Key Differences Explained

Understanding the independent contractor vs. employee distinction is critical in ensuring legal and tax compliance of businesses and self-employed individuals. Misclassification of the two can result in IRS audits, which can lead to severe legal and financial consequences, like penalties and lawsuits.

In essence, employees on a payroll are entitled to minimum wage and various benefits, while employers withhold federal taxes, Social Security, and Medicare taxes from their wages. On the other hand, independent contractors are responsible for their own taxes and don’t receive the same benefits as employees.

With that being said, let’s learn more about the differences and similarities, as well as the pros and cons of independent contractors and employees.

Key Takeaways

• Independent contractors are self-employed professionals who typically work with multiple clients, while employees work for a single company.
• One of the biggest differences between independent contractors and employees is taxes. Employers withhold and pay portions of taxes for employees, while contractors pay for their own in entirety.
• Independent contractors have more autonomy in their work and higher earning potential, while employees have the advantage of income stability, benefits, tax withholding, and legal protection.
• Misclassifying employees as independent contractors can result in severe legal and financial penalties.

Independent Contractor vs. Employee: What’s the Difference?

To understand the differences between independent contractors and employees, we need to examine several key factors. These factors describe relationships between workers and employers or clients, as well as the legal and tax implications.

When looking into potential misclassification, the IRS analyzes how much behavioral and financial control the business has over the worker. That’s why it’s essential to understand the differences in work structure, taxes and benefits, and legal rights and protections.

#1. Work Structure & Control: Who’s the Boss?

A primary and most apparent difference between independent contractors and employees is how much control businesses have over their work.

Employers typically control every aspect of employees’ jobs. The employer sets work hours (e.g., a traditional 9-to-5 work day) and the location where the job will be performed. In addition, they provide employees with the necessary tools and resources and establish company policies that must be followed.

New hires often undergo mandatory training to familiarize themselves with company procedures and work style. On top of that, they usually work under direct supervision and can be asked to make changes and modifications on a daily basis.

On the other hand, independent contractors retain considerable autonomy in their work. They usually set their own hours and develop their own work style and processes. A contract with a client can influence these aspects, but it doesn’t define them entirely.

Independent contractors also choose where they will perform the work, unless the nature of the job mandates differently. They are responsible for obtaining the tools, resources, and supplies needed to provide their services as well.

#2. Taxes & Benefits: What You Need to Know

Taxes and benefits for independent contractors and employees diverge significantly, leading to vastly different financial implications.

Businesses that have employees on their payroll need to withhold their FICA taxes, state income taxes (where applicable), and Social Security and Medicare taxes. On top of that, they pay their share of some of these taxes, while employees pay the other portion.

At the end of the year, employers send Forms W-2 to employees and the IRS. These forms detail employee earnings, benefits, and withholdings, helping them calculate and file their taxes.

Since independent contractors are, by definition, self-employed individuals, they aren’t on the company payroll, and businesses don’t withhold their taxes. Instead, they are responsible for paying the entirety of self-employment taxes to the IRS, comprising both the employer and employee shares.

Independent contractors receive Forms 1099 from their clients instead of Form W-2. These forms detail their income and are used for tax filing purposes.

Finally, independent contractor and employee salaries and compensation packages differ, as employees often have various benefits included. These include health insurance, dental plans, and retirement savings contributions. Contractors usually pay for their benefits on their own.

#3. Legal Rights & Protections: Who’s Covered?

There are numerous federal and state labor laws that provide various rights and protections to employees. For example, they are entitled to a minimum wage and overtime pay (which is at least 1.5 times the regular rate) if their work hours exceed 40 per week.

Employees are also often insured in cases of work-related injuries and illnesses. They are protected by worker rights, which include family and medical leave (FMLA), and they can’t be discriminated against.

Independent contractors aren’t covered by most of these protections. They aren’t entitled to a minimum wage or overtime since they aren’t on a regular payroll. Moreover, since they typically work on a per-contract basis, they don’t receive unemployment insurance payout when the contract ends.

Moreover, independent contractors usually pay for their own insurance and protection. Common types of insurance include general liability insurance, professional liability insurance, and errors and omissions insurance.

Having insurance helps contractors mitigate risks and avoid paying penalties due to unforeseen circumstances or mistakes. Furthermore, some clients may require contractors to have insurance to hire them in the first place.

#4. Common Misclassification Mistakes & How to Avoid Them

Many businesses make the mistake of misclassifying their workers, either accidentally or deliberately (e.g., to save money on taxes and other costs). Mixing up a 1099 independent contractor and a W-2 employee can result in high fines and severe legal consequences.

One common way companies run into the problem of misclassifying a worker is by exerting too much control over the contractor’s work. They attempt to control the work schedule and location, tasks, methods, and more, turning a contractual agreement into an employer-employee relationship.

In these instances, they can be penalized with back payments, missed payroll taxes, unpaid employment contributions, etc. On top of that, they’ll usually have to pay considerable fines imposed by the IRS and other relevant authorities. Workers can also report employers and file lawsuits if they feel they have been misclassified.

To avoid misclassification, businesses should carefully analyze their relationships with employees. They should follow the IRS worker classification guidelines and evaluate behavioral control, financial control, and the parties' relationship. Workers can further seek advice from HR professionals and employment law attorneys.

Pros & Cons of Being an Independent Contractor vs. Employee

Choosing whether to work as an employee or an independent contractor involves analyzing the benefits and drawbacks of both types of classification. One is not inherently better than the other, and understanding the differences can help you choose which model suits you best.

Some professionals prefer autonomy and flexibility, while others rely on the stability of a regular paycheck. Let’s explore the most prominent pros and cons of being an independent contractor vs. an employee to help you determine which structure aligns with your personal and professional goals.

#1. Advantages & Disadvantages of Being an Independent Contractor

Let’s start with the most significant advantages of being an independent contractor:

• Flexibility and autonomy. Independent contractors often set their own work hours and locations. Moreover, they get to choose which clients to sign and which projects to work on. Plus, they develop their own work methods that aren’t influenced by employers.

• Variety. Contractors usually work with multiple clients, which results in increased project diversity.

• High earning potential. Self-employed professionals can choose to increase their rates and charge more per project or per hour, outearning employees who rely on salary increases from employers.

Now, here are the disadvantages of being an independent contractor:

• Income inconsistency. Since they don’t receive regular paychecks, contractors’ pay can be unpredictable and vary significantly from month to month.

• No benefits or tax withholding. Independent contractors are responsible for their own taxes and benefits. They pay the entire amount for Social Security and Medicare, as well as their own time off, retirement contributions, and so on.

• Lack of legal protection. Contractors receive no protection associated with employment, such as minimum wage, overtime, or unemployment.

#2. Advantages & Disadvantages of Being an Employee

After analyzing the pros and cons of being an independent contractor, let’s see the benefits of being an employee:

• Income consistency. By definition, employees are on payroll and receive paychecks on schedule. This makes financial planning easier and contributes to a feeling of safety and stability.

• Benefits and tax withholding. Employee compensation packages offer various benefits in addition to regular salaries. They can be contributions to employee retirement plans, paid time off, or private health insurance. Furthermore, employers withhold taxes and pay for parts of it for employees.

• Legal protection. Employees are entitled to minimum wage and overtime pay. They are protected by wage laws and the Fair Labor Standards Act (FLSA).

Here are the disadvantages of being an employee:

• Less flexibility and autonomy. Employees usually have fixed work hours and set procedures they need to follow. Plus, they are often tied to a location designated by an employer.

• Lower earning potential. Unlike contractors who set their own rates and can always find more clients to increase their earnings, employees mostly depend on raises and thus typically have a lower earning ceiling.

• Overreliance on employers. When it comes to job security, employees rely on businesses and employers doing well, depending on their decisions and success.

Need Paystubs or Tax Forms? Paystub.org Has You Covered!

Whether you’re an employer, an employee, or an independent contractor, you’ll need to do proper record management to ensure tax compliance.

If you’re a business owner with employees on a payroll, you can use our paystub generator to create and send these documents quickly and effortlessly.

Here’s a simple three-step process you can use to generate pay stubs for your employees:

1. Choose a template and color that suits your needs
2. Input relevant information in predesignated areas
3. Review your paystub and go to checkout to download it

The process stays the same if you’re using our Form W-2 generator or if you’re hiring contractors and you need to make Forms 1099.

If you’re an independent contractor, freelancer, or small business, you can just as easily generate invoices with our software solution. Craft professional documents to receive payments and manage your finances securely and hassle-free.

Using online document generators significantly speeds up the creation process and ensures accuracy. With ready-made templates and presets, you don’t have to worry about the design, formatting, or missed information. Plus, digital pay stubs, forms, and invoices are easy to store and file, which further makes the record-management process easier.

Final Thoughts

Choosing to become an independent contractor vs. employee comes down to what type of work style suits you best. Being a contractor might be riskier, but it offers autonomy and higher earning potential. On the flip side, employees can always count on a regular paycheck and benefits.

As a business working with other professionals, it’s critical to avoid misclassifying your workers. Otherwise, you can incur government scrutiny and get into legal and financial trouble.

Ultimately, whether you have employees on payroll or contractors on retainer, you’re welcome to use Paystub.org document generators to create pay stubs, tax forms, and other documents with ease.

Independent Contractor vs. Employee FAQ

#1. Can an independent contractor become an employee?

Yes, an independent contractor can become an employee in multiple ways. Their relationship with the client can change over the course of their collaboration, prompting a revision of the initial contract. Moreover, the IRS or DOL can investigate and mandate the company to start treating a contractor like an employee.

#2. How do I know if I’m being misclassified?

To know if you’re being misclassified, you should examine your relationship with the client and how much control they have over your operations. If they control how, when, and where you perform your work, and they provide the resources and training, chances are you should be classified as an employee.

#3. Do independent contractors get paid time off?

Independent contractors typically don’t get paid time off. Vacation, sick leave, holidays, and similar benefits are generally provided to employees. Since independent contractors are responsible for their own business and schedule, they only get paid while doing work. Unless the contract specifies otherwise, they aren’t paid during their time off.

#4. What’s the biggest tax difference between employees and contractors?

The biggest tax difference between employees and contractors involves payroll taxes. Employers need to withhold a percentage of federal, Social Security, and Medicare taxes for employees while also paying a portion directly to the government. Independent contractors are responsible for the entirety of their taxes and pay them in full.