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

What is the difference between an employee who works for you and someone who also works for you as an independent contractor? You pay payroll (Social Security) taxes for the employee. However, the independent contractor is responsible for paying their own 15.3% in payroll taxes on salary income, but some don’t. This is a major reason why defining employee vs. independent contractor is so important to the government. They need to collect those payroll taxes.

Bob works as a sole proprietor graphic artist. He used to work for many companies, but is now full time with a company. When classified as an independent contractor, the company doesn’t have to pay their 7.65% one half share of Bob’s payroll taxes. But now, Bob is more of an employee. Is either party paying their payroll taxes?

Betty is also a graphic artist, but her situation is different from Bob’s. Betty has her own corporation. She works for many companies and pays the full 15.3% in payroll taxes on the salary she takes from her corporation. Here, Betty is an independent contractor, and in compliance.

But the question of whether a worker is an employee or an independent contractor still doesn’t have a clear answer. Because of this, the U.S. Department of Labor released a new independent contractor rule in an effort to provide better guidance on whether a worker qualifies as an employee or an independent contractor. The rule took effect on March 11^th of this year.

The new independent contractor rule provides an “economic reality test.” This test lists six factors to help determine whether the worker qualifies as an employee or an independent contractor. We will walk through each factor below.

1.) The worker’s opportunity for profit and loss based on managerial skill

The first factor is whether the worker has an opportunity for profit and loss based on their managerial skill. Examples of this include whether the worker can negotiate their pay, accept or decline jobs, or hire others to help them out. If the worker is able to do these things, then they are more likely to be an independent contractor. On the other hand, an employee is more likely to use the assets employers provide them at their fixed office space.

2.) Investments by the worker and the potential employer

The second is whether certain investments are made by either the worker or the independent contractor. These investments include things like buying tools and equipment, renting office space, and paying for marketing costs. If the worker is the one who makes these investments, then they are more likely to be an independent contractor.

3.) Permanence of the work relationship

Number three is the permanence of the work relationship. If the work relationship is indefinite, continuous, or exclusive, then the worker is more likely to be an employee. However, if the work relationship is indefinite, non-exclusive, project-based, or sporadic, then the worker is more likely to be an independent contractor.

4.) The nature and degree of control

The fourth factor is the nature of the work and the degree of control. Examples of this include who has the right to control the work, the schedule, the economics, and whether the employer can supervise or discipline the worker. If the employer controls these aspects, then the worker is more likely to be an employee. But if the worker has more control, then they are more likely to be an independent contractor.

5.) Whether the work performed is a central part of the potential employer’s business

The fifth is whether the work performed is a central part of the employer’s business. If the work performed by the worker is critical, necessary, or central to the employer’s business, then the worker is more likely an employee. However, if the opposite is true, then the worker is more likely to be an independent contractor.

6.) How much workers can use their skill and initiative

The final factor relates to how much the worker can use their skill and initiative. If the worker has more flexibility to use their skill and initiative when completing jobs, then that worker is more likely to be an independent contractor.

Conclusion

This “economic reality test” is not a hard and fast rule to determine whether a worker is an employee or an independent contractor. Know that California has their own, more restrictive rule seeking to categorize more workers as employees, which makes it easier to unionize them. However, this new federal test may provide guidance to business owners who are unsure of their relationship to their workers. As such, it may help employers (as well as Bob and Betty) during tax season.