Independent Contractor vs Employee
Key Takeaways.
- Control Determines Classification: The key factor in determining whether a worker is an employee or an independent contractor is the level of control the business exerts over them. More control suggests an employee relationship, while less control supports independent contractor status.
- IRS Three-Prong Test: The IRS evaluates worker classification based on Behavioral Control, Financial Control, and Relationship Control. Factors such as supervision, training, payment structure, ability to work for others, and provision of tools all impact classification.
- Legal & Financial Risks of Misclassification: Misclassifying employees as independent contractors can lead to significant legal and financial penalties, including back taxes, fines, and government investigations, as illustrated by the case of Patrick and Jason.
- Importance of a Written Agreement: While not definitive, having a well-drafted independent contractor agreement helps strengthen the argument that a worker is a contractor. The agreement should clearly define terms, responsibilities, tax obligations, intellectual property rights, and dispute resolution mechanisms.
- Avoid Non-Compete, Opt for Non-Solicitation: Restricting a contractor from working for other companies may lead to classification as an employee. Instead, businesses should use non-solicitation clauses to protect their interests while maintaining compliance with independent contractor rules.
Determining If Your Worker is an Independent Contractor vs Employee.
If you’re a business owner in New Jersey or New York, you need to know how to protect yourself and your business by understanding the differences between having an employee vs. having an independent contractor. A little background here… A business can classify its workers in one of two ways, either employees or independent contractors. Employees are very expensive because the business needs to pay the wages of the worker but also handle tax withholdings, payroll taxes, employment taxes, and further provide benefits to the employee. Generally, businesses don’t need to do any of that for an independent contractor. Overall, businesses prefer having independent contractors while the IRS and state tax agencies much prefer that a worker is classified as an employee and will pursue any businesses that misclassify their employees as independent contractors. Where is the legal line? It is very vague, but the overall issue is about control. The more control that a business has over the worker, the more likely that worker is an employee, and the IRS has a three-prong test to determine whether a worker is an employee or independent contractor: Behavioral Control, Financial Control, and Relationship Control.
Behavioral Control:
• Amount of Instructions: More instructions = Worker is Employee.
• Detail of Instruction: More details = Employee.
• Systems of Evaluation: More measuring the details of how worker works = Employee.
• Training: More training about procedures and methods = Employee.
Additionally, where does the worker work? At the company’s office? If so, it looks a lot more like an employee versus contractor.
Financial Control:
• Expenses reimbursed? If yes more likely worker = Employee.
• Risk of profit or loss? If worker has little risk more likely = Employee.
• Can worker have other clients? If no, more likely worker = Employee.
• How paid? If regular wage worker likely = Employee, if flat fee likely = IC.
Who is providing the tools or hardware that the worker uses to complete their work? If the business provides same, then it appears that worker is an employee vs. independent contractor. Are there any risks of lost profits? The less risk, the more the worker appears to be an employee. Can a worker have other clients? If they cannot have other clients, it appears the worker is an employee. How is the worker paid? If paid a flat fee, it appears the worker is an independent contractor. What kind of activities does the worker actually do?
Relationship Control: The type of relationship depends upon how the worker and business perceive their interaction with one another.
• Key activity? If yes, likely worker = Employee.
• Worker Benefits (insurance, vacation)? If yes more likely worker = Employee.
• Permanency? If relationship continue indefinitely = Employee, set time = IC.
• Written Agreement? If no likely worker = Employee?
Are there benefits for the worker (insurance, vacation)? Is there a permanent relationship or is it more based on a set agreed upon term? If there’s a defined term, the more the worker appears to be an independent contractor. Finally, is there a written independent contractor agreement?
How do problems arise for companies? Let me tell you a story about my client named Patrick. Patrick owned a general contracting company specializing luxury homes, and had a worker named Jason. Patrick and Jason had a verbal agreement that Jason was an independent contractor and not an employee of Packer. Unfortunately, there was a dispute between the two regarding the quality of Jason’s work and payment to Jason. Jason decided to report Patrick to the New Jersey Department of Labor (as well the NJ Division of Taxation), claiming that he did not receive his benefits as an employee of Patrick. Jason’s complaint triggered an investigation by both the New Jersey Department of Taxation and Department of Labor, which almost resulted in Patrick having to pay thousands of dollars in fines back taxes and interest on his back taxes (not to mention the emotional cost). The lesson here is that if you misclassify employees as independent contractors it can be very costly for you.
Though it is not a final determining factor, it definitely helps you as a business owner if you have a written independent contractor agreement with your worker specifically defining the relationship that there an independent contractor. The screenshots are of a simple New Jersey independent contractor agreement for marketing services.
The independent contractor agreement is dated the 19th of May 2020 and is between Michael Herring and Associates. Section 1.1: As we previously discussed, it is best to have a defined term, and in this case the term of this independent contractor agreement is 18 months. (This obviously strengthens the argument that worker is an independent contractor and not an employee.)
Section 1.3: This is very important paragraph that specifies the independent contractor is acting as an independent contractor not an employee.
In section 2, the compensation is identified, and in this case the independent contractor receives the net profit for selling a software program called “Docuserve”.
Section 2.2, Withholding Other Benefits: This is an important section because it specifically identifies the fact that the business does not have the responsibility to pay or make any contribution for Social Security, local, state, federal tax, and all of those requirements are the duty of the independent contractor.
Ownership of IP you want to make sure as a business owner that you retain all ownership interest in the intellectual property of anything that’s produced by the independent contract.
Section 6, Indemnification: Indemnification is a very complicated topic and it is a section that is highly negotiated by attorneys. In larger deals, I’ve seen indemnification sections that are eight single spaced pages in length. Indemnification is a topic that would require a 3+ hour long video to cover, but for the purpose of this independent contractor agreement, just know that indemnification is compensation for damages or harm suffered by the other party and how the offending party will be required to pay for those damages.
Section 7 Non-Solicitation: Many clients want to me to include language that prevents the worker form working for another company. However, this is often unwise… If you prevent the worker from working for another company the government can argue that the worker is an employee and not an independent contractor. Therefore, what a business can do is have a non-solicitation section in the agreement. In the agreement at hand, during the term of the agreement and for one year after, the independent contractor will not solicit or take away or interfere with the business of the company.
Section 8, Miscellaneous Provisions: In Section 8.4 the parties can select where they want any dispute to be heard, and in this case the parties have agreed to Essex County, New Jersey. Jury waiver: This is something that you may want to include because in the event of any dispute a jury trial can be very expensive. Lawyers will be required to go through the time and effort of selecting jury and then trying the case with the Jury. Often, it is advisable to waive that jury and just have the matter heard and decided solely by the judge.
In conclusion if you want to retain a worker and ensure that worker is classified as an independent contractor, make sure you keep the idea of control in mind. Further, make sure you have a written independent contractor agreement, and speak with a lawyer.
Frequently Asked Questions.
1. What is the key difference between an independent contractor vs employee?
The main distinction lies in the level of control a business has over the worker. Employees follow company schedules, receive training, and work under direct supervision, while independent contractors have more autonomy over how they perform their work.
2. Why do businesses prefer hiring independent contractors instead of employees?
Businesses often choose independent contractors because they are not responsible for payroll taxes, benefits, or tax withholdings. This makes independent contractors a more cost-effective option than employees.
3. How does the IRS determine whether a worker is an independent contractor vs employee?
The IRS applies a three-prong test:
- Behavioral Control: How much training, supervision, and instruction is provided.
- Financial Control: Whether the worker has multiple clients, assumes financial risk, or uses their own tools.
- Relationship Control: The permanency of the working relationship, whether benefits are provided, and if a written contract exists.
4. What are the risks of misclassifying an independent contractor vs employee?
Misclassification can lead to audits, back taxes, penalties, and lawsuits. Government agencies, including the IRS and state labor departments, closely scrutinize businesses to prevent worker misclassification.
5. Does having a written agreement settle the independent contractor vs employee debate?
No, but a well-drafted independent contractor agreement helps support the classification. The contract should outline responsibilities, tax obligations, intellectual property rights, and dispute resolution terms.
6. Can an independent contractor be restricted from working for other companies?
If a business restricts a worker from taking on other clients, it may lead to classification as an employee. Instead of a non-compete clause, businesses should use a non-solicitation clause to prevent workers from taking business away while maintaining independent contractor status.
7. How should an independent contractor be paid compared to an employee?
Independent contractors are generally paid per project or on a flat-fee basis, whereas employees receive regular wages or hourly pay. Receiving structured wages increases the likelihood of being classified as an employee. (But you can set milestones for different types of development projects (tech or otherwise)).
8. What should an independent contractor agreement include?
A strong agreement should cover:
- The specific duration of the engagement.
- Payment terms and tax responsibilities.
- Intellectual property rights.
- Indemnification and liability protections.
- Dispute resolution terms, such as jury waivers and venue selection.
9. Can an independent contractor receive employee-like benefits?
Providing benefits such as health insurance, paid time off, or retirement plans can make a worker appear more like an employee, increasing the risk of misclassification.
10. How can businesses ensure they comply with independent contractor vs employee laws?
Business owners should consult a lawyer (I can help) to review their worker classifications, draft clear agreements, and ensure compliance with IRS and state labor regulations to avoid penalties.
Conclusion.
Understanding the distinction between independent contractor vs employee is critical for business owners to avoid costly legal and financial consequences. The level of control, financial arrangement, and nature of the working relationship all play a role in classification. Misclassification can lead to IRS audits, fines, and potential lawsuits, making it essential for businesses to properly define worker roles from the start.
A well-drafted independent contractor agreement can help reinforce the worker’s status, but it is not the sole determining factor. Ensuring compliance with IRS guidelines, avoiding restrictions that resemble employment terms, and consulting a lawyer can help safeguard your business. By taking proactive steps, businesses can structure their workforce effectively while minimizing risks associated with misclassification.
If you have any questions or need legal guidance on independent contractor vs employee classification, please reach out to me here.
John M. Shari is a seasoned business and real estate attorney with over 20 years of experience. As the founder of Law Offices of John M. Shari, LLC, he represents clients in complex real estate transactions, commercial leasing, business acquisitions, private placements, secured financing, and entity formations. His background includes serving as Lead Acquisitions Counsel at Diamond Communications and practicing at respected law firms, where he honed his skills in structuring and negotiating high-value deals. John is committed to providing legal guidance tailored to each client’s needs.