Employee vs. Independent Contractor: What’s the Real Difference?

Whether you’re hiring your first employee or managing a growing team, understanding the difference between an employee and an independent contractor is essential. Worker classification affects how you handle payroll taxes, benefits, and reporting requirements—and misclassification can result in costly IRS penalties. Many business owners unintentionally get it wrong, often because the rules are complex. The IRS, Department of Labor, and various state agencies each use their own criteria to determine worker status, which can make compliance especially challenging.

Employee vs. Independent Contractor: The Basics

Understanding how employees and independent contractors differ is key to determining the right classification for your workers. The main distinction comes down to the level of control and responsibility in the working relationship.

Employee (W-2):

• Works under the employer’s direction and control.

• Has taxes (federal, state, Social Security, and Medicare) withheld by the employer.

• May be eligible for benefits such as paid time off, health insurance, and retirement contributions.

Independent Contractor (1099):

• Operates as a self-employed individual or business.

• Controls how, when, and where the work is performed.

• Handles their own tax payments and business expenses.

• Does not receive employee benefits or tax withholding from the hiring company.

Who is Considered Self-Employed?

Self-employed individuals run their own business and are not considered employees of another company. This includes:

• Independent contractors – Freelancers or consultants who provide services to multiple clients.

• Sole proprietors – Business owners operating under their own name or a trade name.

• Partners – Certain partners in a business who are active in the operation of the company.

How to Tell the Difference 

Determining whether a worker is an employee or an independent contractor depends on the facts and circumstances of the working relationship. The IRS Common Law Rule evaluates the level of control the business has and independence of the worker, focusing on three key areas:

1. Behavior Control

   This refers to how the work is performed and the level of direction the business provides:

   • Employee:

     • Work hours are set by the employer.

     • Instructions and training are provided on how to complete tasks.

     • Work is ongoing or part of the company’s regular operations.

   • Independent Contractor:

     • Operates on a project-based or short-term engagement.

     • Controls how, when, and where the work is performed.

     • Receives minimal direction from the business regarding methods.

   
   

2. Financial Control

   This examines who manages the financial aspects of the work:

   • Employee:

     • Paid a regular wage or salary.

     • Uses tools, equipment, and resources provided by the employer.

     • Limited opportunity to earn a profit or experience a loss.

   • Independent Contractor:

     • Sets their own rates or fees.

     • Provides and maintains their own tools and equipment.

     • Has the potential to earn a profit or incur a loss based on how they manage the work.

3. Type of Relationship

   This looks at how the business and worker perceive their working relationship:

   • Employee:

     • Often has a written contract or job offer outlining ongoing employment.

     • May receive benefits such as health insurance, retirement contributions, or paid time off.

     • Relationship is typically long-term or indefinite.

   • Independent Contractor:

     • Works under a project-based or short-term agreement.

     • Does not receive company-provided benefits.

     • Relationship usually ends when the specific project or task is complete.

Some states, including California, Massachusetts, and New Jersey, use a stricter standard known as the ABC Test. Under this test, a worker is presumed to be an employee unless the business demonstrate that all three of the following conditions are met:

• (A) is free from control in performing the work,

• (B) performs work outside the company’s usual business, and

• (C) is engaged in an independently established trade or business of the same nature.

In Missouri and Kansas, the IRS common Law Rule is generally followed. These states evaluate the facts and circumstances of the working relationship, considering factors such as control, financial independence, and how both parties view the relationship to determine proper classification.

Proper classification ensures your business meets all federal and state requirements while protecting you from potential penalties and back taxes.

Why Worker Classification Matters

Correctly classifying workers is essential for compliance and financial protection. Misclassifying an employee as an independent contractor can lead to significant IRS and state penalties, along with interest on unpaid taxes.

The IRS penalties business may face include:

• Failure-to-deposit penalty: 1–15% of the payroll taxes that should have been withheld, depending on how late they are deposited.

• Failure-to-pay penalty: 0.5% per month of unpaid payroll taxes, up to 25% of the amount due.

• Interest on unpaid taxes: Interest accrues daily from the due date until the date of payment.

• Form filing penalties: $60–$340 per missing or late Form W-2 or 1099, or $660+ per form for intentional disregard, with no maximum.

• Trust Fund Recovery Penalty (TFRP): Responsible parties can be held personally liable for 100% of unpaid employee payroll taxes if the failure to withhold was willful.

Importantly, employers are also responsible for their share of payroll taxes (the employer portion of Social Security and Medicare) for misclassified employees, in addition to the amounts that should have been withheld from the employee. Beyond federal penalties, employers may also owe unpaid state unemployment insurance, workers’ compensation contributions, and related interest and penalties.

Correctly classifying workers as employees or independent contractors is essential for staying compliant with federal and state tax laws, avoiding costly penalties, and ensuring fair treatment for your team. Employees have taxes withheld and may receive benefits, while independent contractors manage their own taxes and operate their own businesses. Misclassification can lead to back taxes, penalties, interest, and even personal liability for responsible parties.

By understanding the key differences, using proper contracts, and reviewing both IRS and state guidelines, you can protect your business, maintain transparency, and support a workforce that is classified correctly. When in doubt, we can help ensure you make the right decisions and avoid potential pitfalls. If you would like to discuss workforce classification and staying compliant with IRS rules, email jessica@fpgtax.com or call (816) 941-2900 to schedule a meeting or phone call.