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How do I determine the difference between an employee and an independent contractor?

Richard Scrivanich, February, 2005

The following is a general guideline for resolving the difference between an employee and an independent contractor.

The distinction between whether a worker is an employee or an independent contractor is an important one. If your worker is an employee, you must generally withhold income taxes and withhold and pay Social Security, Medicare, and unemployment taxes on his or her wages. You do not generally have to withhold or pay these taxes on payments to independent contractors.

The decision also affects eligibility for employee benefits. For example, employees may be eligible for workers’ compensation, unemployment benefits, group insurance (including life and health), and retirement benefits, while independent contractors need not be covered.

Finally, the proper classification can help you avoid significant tax penalties.

Defining the business relationship

Whether a worker is an employee or an independent contractor depends on issues of control and independence. Generally, a worker is considered an independent contractor if the employer has the right to control or direct the result of the work, but not the means or methods of accomplishing the result.

Someone who works for you is generally considered an employee if you can control what will be done and how it will be done. This is so even when you give the employee freedom of action. What matters is that you have the right to control the details of how the services are performed.

Control and independence fall into three categories: behavioral control, financial control, and the type of relationship of the parties.

Behavioral control includes whether the business has a right to direct and control how the work is done through instructions, training, or other means.

Financial control includes facts showing whether the business has a right to control the financial and business aspects of the worker’s job, including:

  • The extent to which the worker has unreimbursed business expenses,
  • The extent of the worker’s investment in the tools or facilities used in performing services,
  • The extent to which the worker makes his or her services available to others in the relevant market,
  • How the business pays the worker, and
  • The extent to which the worker can realize a profit or incur a loss.
The type of relationship includes:
  • Written contracts describing the relationship the parties intended to create,
  • The extent to which the worker is available to perform services for other, similar businesses,
  • Whether the business provides the worker with employee-type benefits, such as insurance, pension plan, vacation pay, or sick pay, and
  • The permanency of the relationship, and the extent to which services performed by the worker are a key aspect of the regular business of the company.
Note that these same issues apply in determining whether a household worker is an independent contractor or an employee.