What is the Difference Between an Independent Contractor and an Employee?

People often ask me about the difference between an independent contractor and an employee. Nowadays, due to the significant savings on payroll taxes, liability insurance etc, many small business owners would rather hire independent contractors than commit themselves to an employer-employee relationship with their workers.

Regardless of the written agreement the business may have with that person, there are certain rules which the IRS employs in determining whether it's an independent contractor relationship or not.

To stay on the safe side and avoid potential costly penalties, you should be aware of those rules. They are called the "20 Common Law Factors". Here is how they describe an employee:

1. Instructions. An employee must follow the employer's directions regarding the work.

2. Training. An employee receives training from or under the direction of the employer.

3. Work essential to the company. An employee provides services that are essential to the business.

4. Work performed personally. An employee provides services that must be rendered personally.

5. Control their own assistants. An employee cannot hire, supervise or pay his own assistants at his sole discretion.

6. Continuing relationship. An employee has a continuing relationship with the company.

7. Working hours. An employee must follow set working hours.

8. No time available to pursue other employment. Usually an employee works full time for the employer and has no time available to pursue other gainful work.

9. Job location. An employee performs all or most of his work on the employer's premises. If they work elsewhere, it is at the company's direction and supervision.

10. Set order of work. An employee must do his work in the order determined by the employer.

11. Interim reports. An employee must submit periodic progress reports to the employer.

12. Timing of Payment. An employee is paid for time worked, weekly, monthly, etc.

13. Business expenses. An employee receives reimbursement for travel and other business expenses.

14. Tools and materials. An employee depends on the company for his tools and materials.

15. Amount of investment. An employee has no big investment in the facility or tools needed for his work.

16. Profit or loss. An employee cannot suffer a loss based upon his own services.

17. One employer. An employee works for only one employer or company at a time.

18. Services available to the public. An employee does not offer his services to other companies or the public.

19. Right to discharge. An employee can be fired by the employer.

20. Right to quit. An employee may quit at any time without suffering any liability.

Basically, an independent contractor will be someone who has the opposite relationship with the hiring firm to that of an employee.

Even if a person is an independent contractor under these common law rules, he or she may nevertheless be treated as an employee by statute ("statutory employee") for certain employment tax purposes, if he or she falls within any one of the following four categories:

Statutory Employees:

1. Food and laundry drivers.

2. A full-time life insurance sales agent working mainly for one life insurance company.

3. At-home worker who is supplied with materials or goods which must be returned to you or to a person you name, if you also furnish specifications for the work to be done.

4. A full-time traveling or city salesperson who sells goods to people (or businesses) for resale.

Social security and Medicare taxes

You need to withhold social security and Medicare taxes from the pay of statutory employees if all three of the following conditions are met:

1. The service contract states or implies that most of the services are to be performed by them personally.

2. They do not have a substantial investment in the equipment and tools used to render the services.

3. The services are rendered on a continuing basis for the same firm.

Lucy Rudnicka is a former Corporate Controller. She now owns her own Accounting Services firm - "FINANCIALS for You" - and works primarily with small businesses by providing them with outsourced bookkeeping, business plan preparation, part-time Controller services and professionally designed financial templates.

She believes that every business, no matter how small, needs accurate and timely financial statements. Once those financials are available, you can start analyzing your results with financial ratios. Download a profit and loss template with ratios and start looking at your business differently today!