Employee vs. Contractor: What’s the Difference?
As we near the end of 2024 and gear up for tax season, we want to answer one of our most asked questions: What is the difference between an employee and a contractor?
Contractors can be a great option if you need some help taking tasks off your plate or tackling a specialized project. However, there are several things you need to consider to make sure you don’t end up facing consequences like back pay or even criminal charges.
Client Question: “Why can’t every worker be classified as a contractor?”
The consequences of incorrectly classifying an employee as a contractor can result in back wages and interest, criminal charges, and penalties. But, why exactly does the government care so much about whether you’re calling a worker a contractor or an employee?
Employees are entitled to certain protections under the Fair Labor Standards Act (FLSA) like minimum wage and overtime pay. Incorrectly classifying an employee as a contractor removes those legal protections. Check out the next page for the Department of Labor’s Economic Reality Test Factors to help with contractor classification.
Employees and contractors are also treated differently from a tax perspective. Generally, a business does not need to withhold any taxes from a contractor’s pay. Taxes become the contractor’s responsibility.
Economic Reality Test Factors
Opportunity for profit or loss depending on managerial skill
Investments by the workers and the employer
Degree of permanence of the work relationships
Nature and degree of control
The extent to which the work performed is an integral part of the employer’s business
Skill and initiative
*information sourced from DOL.gov
Five Things that don’t *Actually* Determine if Someone is a Contractor
Whether you (or they) call themselves a contractor
Whether you issue them a 1099
How often you pay them or your payment method
Whether you have a written contractor agreement
Whether they are able to work offsite or have flexible working hours
Client Question: “Why do I need a signed W-9 from a new contractor?”
Before you ever issue a payment to a contractor, it’s important that you have their signed W-9 on file. This form provides important tax information like your contractor's SSN or EIN, business name, federal tax classification, exemptions, and mailing address.
Without this information, you won’t know whether you should or shouldn’t issue a 1099 to your contractor, whether you should be withholding backup taxes, or which tax ID number to use when issuing a 1099.
Failing to collect this information can lead to penalties for both you and your contractor. If a contractor refuses to provide a W-9, you should document the written refusal and consider whether you still want to move forward with your business relationship.
How to Pay your Contractors
When paying your contractors, avoid personal payment apps (Venmo, CashApp, Zelle, etc).
These apps don’t typically have formal protection for business payments or required tax reporting for businesses. For some apps, sending business payments can even be a violation of their terms and conditions.
Instead, we recommend paying contractors using business checks, business credit card payments, ACH or business bank account transfers, or professional payment platforms (Bill.com, Melio, QuickBooks, or Gusto).
New Contractor Onboarding Checklist
Before working with a new contractor, it is wise to lay out your agreement in written form to include duties, payment and all necessary paperwork.
Draft and have both parties sign a written contractor agreement
Collect a signed Form W-9 before issuing payment
Define payment terms and collect their payment information
Verify that the contractor is correctly classified (not an employee)
Review any insurance requirements and proof of liability
Ensure all tax and legal documentation is in the contractor’s company file
Make all necessary team and client introductions