Employee vs. Contractor: How to Classify Workers Correctly

Misclassifying workers can lead to serious legal and tax consequences, yet many businesses struggle to determine whether someone should be classified as an employee or an independent contractor. Understanding the key differences is crucial for startups, small businesses, and even freelancers hiring subcontractors in Boulder and Kansas City.

How to Classify Workers: The IRS Three-Factor Test

The IRS and most state agencies determine worker classification based on three primary factors: 

1. Behavioral control
2. Financial control
3. The type of relationship. 

Each of these factors is evaluated based on several indicators, which help businesses determine whether a worker should be classified as an employee or an independent contractor. While the business makes the initial classification (and often favors contractor classifications), their classification can be overruled by various government agencies.

1. Behavioral Control: Who Dictates the Work?

Businesses must assess how much control they have over how, when, and where work is performed. Even just having the right to exert this control can be enough.

• Control and Independence: If a business dictates the worker’s schedule, work methods, or requires training, the worker is more likely an employee. Contractors typically decide how to complete their work.
• Equipment and Resources: If the business provides tools, software, or office space, the worker is more likely an employee. Contractors usually supply their own equipment.

2. Financial Control: Who Manages Expenses and Profitability?

Financial arrangements also help determine worker classification.

• Payment and Benefits: Employees receive a set salary or hourly wage on a regular schedule and may receive benefits like health insurance and paid time off. Contractors are often paid per project or milestone and do not receive benefits.
• Investment in the Work: Employees rely on the company to provide materials, while contractors make their own financial investments in tools and resources.
• Opportunity for Profit or Loss: Contractors can profit based on efficiency and cost management, while employees earn a set wage regardless of these factors.

3. Type of Relationship: What Do Contracts and Expectations Say?

The nature of the working relationship also impacts classification.

• Term and Termination: Employees usually work indefinitely and can be terminated at will, while contractors work under agreements specifying project duration and termination conditions.
• Written Agreements: Employment agreements typically outline job duties, compensation, and policies, while contractor agreements define project scope, payment terms, and intellectual property ownership.
• Benefits and Long-Term Expectations: If a worker receives benefits or has an expectation of continued employment, they are more likely an employee.

Tax Considerations for Employees and Contractors

Employees

• Employers must withhold income taxes and pay a portion of the employee’s Social Security and Medicare taxes.
• Additional costs may include workers’ compensation insurance and unemployment tax contributions.
• Many businesses use payroll services to streamline tax compliance. I prefer Gusto. You can use my referral link to get a discount.

Contractors

• Contractors handle their own tax withholdings and must pay self-employment taxes.
• Businesses do not withhold taxes but must issue a 1099 if payments exceed $600 annually.
• Before issuing payments, businesses should collect a W9 from contractors for tax reporting purposes.

Intellectual Property Considerations

Employees

• Work created by employees within the scope of their job typically belongs to the employer.
• Employment agreements should explicitly state intellectual property ownership to avoid disputes.

Contractors

• By default, contractors own the work they create, even if they were paid for it.
• A written contractor agreement should include an intellectual property assignment clause or work-for-hire language to ensure ownership rights transfer to the business.

Other Legal Considerations

Confidentiality and Non-Solicitation

• Employers may require NDAs (Non-Disclosure Agreements) for both employees and contractors to protect sensitive information.
• Non-solicitation clauses can prevent former workers from poaching clients or employees after leaving the company.

Non-Compete Agreements

• Some businesses require non-compete agreements, though enforceability varies by state.
• These are more commonly applied to employees than contractors.

Key Takeaways

• Misclassification can result in fines, back taxes, and legal liability.
• Employees have taxes withheld, receive benefits, and work under company control.
• Contractors manage their own taxes, work independently, and retain ownership of their work unless stated otherwise.
• Written contracts are essential for defining terms and protecting business interests.

Carefully considering classification factors before hiring can help businesses in Boulder and Kansas City avoid legal and financial risks. If in doubt, consulting an attorney or accountant is always a smart move.

*This article is general in nature and is not legal advice.