Employee vs. independent contractor: What’s the difference?

And why does it matter?
Sterling Miller

Twenty years ago, the use of independent contractors (or, freelancers) by established businesses was not that common. This has changed dramatically, especially over the past five to ten years as the “gig economy” has taken off and employers are relying more and more on independent contractors instead of employees. While such use can provide a lot of benefits, it also presents a lot of risks and small business lawyers are at the forefront of helping companies mitigate these risks. Fortunately, Practical Law provides a lot of resources to aid in-house lawyers in this responsibility.

See Practical Law: Independent Contractor Tool Kit

Independent contractors vs. employees: The differences

Employers like to use independent contractors when they can because doing so allows them to avoid expenses associated with employees — taxes, training, promotions, overtime, benefits, unemployment insurance, workers’ compensation insurance, FMLA leave, 401K matches, and so on. And, they can plug gaps in their employee workforce by bringing in someone who has the necessary experience to hit the ground running.

The problem is, of course, that employers can come to over rely on independent contractors and, over time, begin to treat them as employees. When this happens, big problems arise for the company despite any good intentions on their part or on the part of the contractor.

See Practical Law: Classification of Independent Contractors (PowerPoint presentation)

There are numerous tests different regulators use to determine if a worker is truly an independent contractor or an employee; the Department of Labor and Social Security Administration use the “economic reality” test. Many states use a three-factor “ABC” test, though each state’s law varies, sometimes substantially. The IRS uses an 11-factor test based largely on the ability of the company to direct and control the worker as they perform their duties.

For more on these different tests see Practical Law: Using Independent Contractors and Outside Firms: Avoiding Employee Misclassification

While it is important to understand all the applicable tests, here are the core factors to focus on when doing a quick analysis as to whether an independent contractor should, in fact, be classified as an employee:

  • Where, when, and how is the work performed? Is the contractor working remotely or on-premise? Do they have set hours or flexibility to work when they want? Is the employer providing the tools needed to do the job or is the contractor?
  • Does the employer train the contractor on how to do the work?
  • Is the work temporary or is it ongoing? Does the project have a specific endpoint? Has the contractor been working for the company for more than one year?
  • Does the contractor have the autonomy to do the work in the manner they see fit, or does the employer direct their actions beyond basic instructions?
  • Is the contractor free to accept work from other businesses?
  • Is the employer deducting taxes from payments to the contractor?
  • Is the contractor treated like an employee? That is, do they have a company email address (which does not designate them as a contractor); receive performance reviews along with company employees; are they subject to the company’s discipline process; receive announcements intended for employees, attends staff meetings, parties, and other employee events; and so on? Treating the contractor as an employee is, perhaps, the most common place where employers trip up and transform the contract relationship into an employee relationship.

Independent contractors vs. employees: The risks

There is, of course, more. But, if you are on the lookout for these factors, you will likely catch most of the problems before they become serious.

See Practical Law: Independent Contractor Classification (practice note)

Unfortunately, if the company gets the classification of independent contractors wrong, bad things can happen. The company could be liable for employment taxes, back wages (including overtime), unemployment insurance claims, workers’ compensation claims, violations of the FMLA, claims involving benefits, and more. The Department of Labor regularly audits companies for compliance and an aggrieved contractor can file a lawsuit, including one seeking class-action status.

Consequently, it is critically important that in-house counsel take steps to ensure the company is engaging independent contractors in the right manner. Also, they should do this in partnership with the human resources department.

See Practical Law: Evaluating and Engaging Independent Contractors Checklist

Independent contractors vs. employees: Procedures that safeguard

Here are a few things in-house counsel can do to be proactive when it comes to reducing the risks presented by engaging independent contractors:

  • Prepare a policy setting out who, when, and how the company may engage independent contractors.
  • Ensure all managers are trained on the policy and how to properly treat and work with independent contractors.
  • Create a process where the legal department and human resources are notified when any independent contractor has been working for the company for one year or more — and then evaluate the engagement to ensure the company is not treating the contractor as an employee.
  • Have a standard independent contractor agreement that properly sets out the terms of any such engagement.
  • Know the federal and state laws for every location where the company has employees and have experienced employment law counsel already lined up in the event there are issues or questions.
  • Discuss the risks and concerns around engaging independent contractors with senior management to help ensure no one believes it is a path to avoid when hiring employees — it’s not.

See Practical Law: State Q&A Comparison Tool – Independent Contractors and Independent Contractor/Consultant Agreement (Pro-Client)

There are many ways in-house counsel can demonstrate their value to the company. Being proactive about employment law issues, especially issues involving the proper classification of independent contractors, is near the top of the list. With Practical Law, you are only minutes away from finding up-to-date and useful answers, forms, practice notes, and checklists about all the company’s employment law questions. It has never been easier to get the right advice at the right time.

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