Independent Contractor: Definition, Pros & Cons, And More
An independent contractor is a self-employed individual who offers services to clients under set terms elaborated in a contract agreement. To be considered an independent contractor, an individual must meet a specific set of criteria, which can vary depending on the jurisdiction they live and work in.
This article will clarify the difference between independent contractors and employees, outline the pros and cons of hiring or being an independent contractor, and explain the ins and outs of employee misclassification. I’ll also explain how an Employer of Record (EOR) can reduce the challenges of working with indepedent contractors and ensure your business remains compliant with labor and tax laws.
Using independent contractors can be a strategic move, but it requires thorough understanding and careful management.
What is an Independent Contractor?
An independent contractor, otherwise known as a freelancer or consultant, is a self-employed individual who offers specified services to clients under terms that are negotiated and defined in a contract. These individuals are responsible for paying their own taxes, arranging their own benefits, and acquiring necessary insurance.
Different jurisdictions have their own unique laws governing independent contracting, but in general, an independent contractor must maintain independence from the client's business.
They must exhibit a substantial degree of control over their work, including the ability to set their own hours, define the scope of their work, and decide on the process and methods of completion. They also must bear any financial responsibilities required to fulfill their contract, including the cost of any tools or resources they need to access.
Independent contractors typically work on a project-to-project basis, and they can offer their services to multiple clients simultaneously. Lastly, contractors typically invoice for services rendered and do not receive a traditional paycheck like employees.
Independent Contractors vs. Employees
To help you understand the crucial differences between independent contractors and employees, I’ve broken down each worker classification in more detail.
Independent Contractors
An independent contractor is a self-employed individual who provides services to clients while maintaining control over how these services are delivered. They are not salaried employees; instead, they are paid based on the terms of their written contract which often specify payment upon the completion of the job or upon reaching key project milestones.
They are also responsible for managing their own tax payments, which means they are not subject to withholding or payroll taxes. In addition, independent contractors must secure their own insurance coverage according to the regulations of their trade, such as general liability and errors & omissions insurance.
Full-Time Employees
In contrast, employees work under an employer's direct supervision, adhering to set hours and using employer-provided tools. They are paid at a regular cadence according to their employment contract and are subject to payroll taxes and other withholdings according to the legal requirements of their jurisdiction.
As an employee, individuals are eligible for other benefits such as paid vacation time, paid sick leave, extended health insurance, disability & life insurance, and long-term retirement savings vehicles, such as a 401K or a Retirement Savings Plan (RSP). Employees are also covered by their company’s insurance coverages including general liability and errors & omissions insurance.
Key Comparison Table for Independent Contractors vs Employees
| Worker’s Status | Independent Contractor | Employee |
| Working Relationship | May work for multiple clients or companies simultaneously. | Works for one client or company. |
| Length of Relationship | Contractual for a specific task or short-term period. Often project-based. | Ongoing employment relationship with no specified end date. |
| Degree of Control | Client has limited control over how and when the individual completes their work. | Work is completed according to the employer’s requirements, including when and how the work is completed. |
| Resources, Tools, and Equipment | Responsible for sourcing items, including the costs of repairs and maintenance, unless otherwise specified in a contract.1 | The cost of all tools, equipment, and resources are covered by the employer. |
| Employee Benefits | Not eligible for group benefits. They must seek personal plans instead. | Often entitled to comprehensive employee benefits through group plans, including health and dental insurance, disability and life insurance, pension plans, etc. |
| Payments & Taxes | Paid irregularly according to their contract agreement. Contractors submit invoices for payment and pay self-employment taxes. | Paid a regular hourly wage or salary via payroll, including typical employment taxes and payroll deductions. |
| Required Tax Forms (USA only) | IRS Tax Form W-9 IRS Tax Form 1099-NEC IRS Tax Form 1096 | IRS Fax Form I-9 IRS Tax Form W-4 IRS Tax Form 941 or Form 944 IRS Form 940 IRS Form W-2 |
1 Many independent contractors do charge additional fees to clients for using specialized equipment, or they may roll these costs into their hourly fee.
The Internal Revenue Service (IRS) has also set guidelines to differentiate between independent contractors and employees. These are based on three categories:
- behavioral control (who has the right to direct and control the work performed),
- financial control (the business aspects of the worker's job), and
- the relationship of the parties involved.
These criteria serve as a legal framework, and if not properly classified, it could result in significant legal and financial implications for a business.
Who Can Be an Independent Contractor?
Virtually anyone can become an independent contractor, provided they possess the skills and expertise desired by businesses.
Independent contractors span numerous industries - from freelance writers to graphic designers, software developers, electricians, consultants, and many other types of specialists. Essentially, if there is a professional service to be offered, there is a potential for independent contractor work.
However, being an independent contractor isn’t for everyone. To be successful requires not only expertise in a specific field but also enough business acumen to run your own business, including handling financials and maintaining client relationships. This requires a much different skill set than being an employee.
A person with an entrepreneurial spirit, the ability to work independently, and the willingness to absorb both the risks and rewards of business ownership is an ideal candidate for becoming an independent contractor.
Hiring an Independent Contractor
When engaging an independent contractor, it's crucial to evaluate their qualifications, professional background, references, and experience to ensure they're capable of performing the tasks. The contractor should have a Federal Taxpayer Identification Number and be responsible for their own business taxes.
In the agreement, the tasks and services should be clearly outlined and both parties should be explicit about expected results, deadlines, compensation, and how to resolve any potential disputes.
Also, ensure that the independent contractor complies with all relevant industry regulations, laws, and professional standards - including obtaining their own insurance.
Pros and Cons of Hiring an Independent Contractor
Hiring an independent contractor does offer several advantages to businesses that need to access specialized skill sets temporarily. However, the decision to work with an independent contractor needs to be considered carefully against some of the potential drawbacks.
The Pros
Here are some of the advantages of working with an independent contractor:
- Reduced operational costs that are often required for full-time employees (e.g., workers’ compensation, health benefits, retirement contributions, and paid time off)
- Access to specialized skills without needing to invest in extensive training costs or resources
- Greater flexibility in work arrangements, including the ability to adjust the scope of the independent contractor’s involvement in tasks based on fluctuating project demands
The Cons
However, some downsides need to be considered when hiring independent contractors, including:
- Contractors may work with multiple clients simultaneously, slowing their output
- Potential issues with loyalty and company allegiance
- Potential problems with confidentiality and competition
- Lack of company control over contractors can also be challenging (limited control over output, expectations, or level of effort, etc.)
- Potential employee misclassification issues, leading to legal issues, unpaid taxes, and penalties
If you’re considering hiring an independent contractor, it's important to weigh the pros and cons carefully for your business and each specific project.
Being an Independent Contractor
If you have your heart set on becoming a non-employee, make sure to consider all the angles before you declare your new independent contractor status. To help you make that decision, I’ve summarized the key pros and cons of this worker classification below.
Pros and Cons of Being an Independent Contractor
Being an independent contractor comes with several advantages as well as potential challenges. To give you a more informed perspective of what it’s like to be a sole proprietor, here’s a quick summary of the key pros and cons.
The Pros
Being a small business owner does offer many advantages that aren’t available to full-time employees, including:
- Flexibility in terms of work schedule, location, and assignments
- Full autonomy regarding who to work for, the type of work you want to do, and when you want to do it
- An increased sense of control over your career
- The potential to earn more than your employed counterparts because you can negotiate your pay rates and work for multiple clients simultaneously
- The fringe benefit of potential tax deductions for business expenses
The Cons
Before you launch your small business of one, take some time to consider the potential challenges you may face along the way, so you can make an informed decision. These include:
- A lack of certain benefits such as health insurance, retirement plans, and paid vacations (this can be problematic in the event of a medical emergency or during retirement)
- Sole responsibility for managing your income tax requirements and social security tax contributions
- The common reality of working longer hours to meet client requirements, especially when working for multiple clients simultaneously
- No guaranteed job security since clients can decide to terminate contracts at any point
- Potential periods of no work, which can lead to financial instability
- A potential feeling of isolation and lack of camaraderie found in traditional workplace environments
Paying an Independent Contractor
Although payment methods might differ from contractor to contractor, the most common method is via invoicing. The contractor submits an invoice for their work to their client, which the company then pays within an agreed time frame. Make sure to have a written contract that clearly stipulates the payment terms, scope of the project, and other necessary details to ensure clarity and prevent disputes.
In addition, advanced payroll software or contractor management systems can help you streamline the payment process. These software solutions can help you to track and document payments, ensuring that all invoices match contract agreements, and all transactions are recorded and available for future reference.
You’ll also need to file IRS Form 1099-NEC if you pay an independent contractor $600 or more during the year. This form reports the income to the IRS and the contractor, ensuring you stay compliant with tax regulations.
Employer of Record Service
An Employer of Record (EOR) service is an alternative option to consider for companies planning to partner with independent contractors. An EOR essentially takes on the legal and administrative responsibilities of being an employer, including HR, payroll, tax, employee benefits and liability coverage. As part of this process, they also use a robust worker classification process to verify the independent contractor relationship and eliminate the possibility of employee misclassification errors.
Working with an EOR enables businesses to sidestep the intricacies of employment law and regulations, simplifying the process of engaging with independent contractors. This option offers the most peace of mind for HR and payroll administrators, as it lifts the burden of liability and compliance off of your company, and into the realm of the EOR provider.
An EOR can also assist companies by managing contractors in geographical areas where the client company has no established entity. The Employer of Record acts as a local entity, hiring the contractor on behalf of the company and subsequently leasing their services back to the company. This allows businesses to bypass complex international employment laws and taxation systems, hence providing a streamlined and efficient solution.
Global Payroll Service
If you’re planning to use independent contractors on a global scale, working with a global payroll service is also worth considering. Global payroll services ensure accurate, consistent, and compliant payments to contractors or employees across numerous countries. They also make reconciliation and reporting an easy task, offering an integrated view of all contractor payments.
Many EOR providers actually offer global payroll services for a reduced fee, while still offering services to manage compliance and monitor for possible employee misclassification issues.
Why is Employee Classification Important?
The importance of correct worker classification stems from its financial, legal, and administrative implications. For instance, in the US the IRS uses employee classification to determine payroll taxes, while the Department of Labor refers to it when applying federal labor and wage laws.
Independent contractors aren’t subject to the same tax deductions and legal protections as traditional employees, so employee misclassification can lead to underpaid taxes, legal actions, and penalties.
In addition, employee misclassification can impact workplace dynamics and affect the employer-employee relationship. As an employer, you might accidentally erode trust and mismanage resources if, for instance, full-time employees perceive independent contractors as receiving preferential treatment.
Correct worker classification ensures transparency, compliance, and fairness in a company's operational functionality, while avoiding labor disputes, tax complications, and potential litigation. It helps to create a harmonious workplace environment, ensuring that everyone’s rights and responsibilities are treated equally and fairly.
Misclassification Risks
Misclassifying an employee as an independent contractor can lead to significant legal issues and financial consequences for an organization. This is mainly because the statutory rights and benefits accorded to an employee significantly differ from those of independent contractors.
The most common risks involve tax liabilities, where the employer should have been withholding and remitting taxes but failed to do so. Organizations may also face retroactive wage claims, employee benefits disputes, and fines or penalties from government agencies.
Additionally, misclassification can result in back payments for benefits like health insurance, retirement contributions, or paid time off that the independent contractor would have received as an employee.
There is also the risk of exposure to related claims, like discrimination, wrongful termination, or retaliation claims. If a company is not careful with its worker classification process, it could potentially face unexpected and avoidable financial liabilities. That’s why it’s essential for an organization to understand the legal definitions and differences between an employee and an independent contractor.
IRS Classification Rules
The IRS has strict classification rules for determining whether an individual is an independent contractor or an employee. Their primary criteria revolve around the degree of control and independence in the relationship between the worker and the employer.
The IRS looks at three categories:
- Behavioral control
- Financial control, and
- The type of relationship of the parties involved.
Behavioral control refers to the level of instruction given to a worker, including when and where to work, what tools to use, or where to purchase supplies.
Financial control considers the business aspects of the worker’s job, such as the extent to which the worker has unreimbursed business expenses, the level of investment in facilities used by the worker, and how the business pays the worker.
With the relationship of the parties, the IRS assesses factors such as written contracts and the permanency of the relationship.
It's crucial to get this classification right as it affects tax obligations, benefits, labor law rights, and more.
DOL Status Test
The Department of Labor (DOL) uses a specific status test to determine whether an individual is categorized as an independent contractor. The test, also known as the "economic realities" test, considers the degree of the worker’s economic dependency on the employer. Its main focus is not on the level of control an employer has over a worker, but rather, if the worker is economically dependent on the employer.
Key factors in the DOL status test include:
- the nature and degree of the worker's control over the work,
- the worker's opportunity for profit or loss,
- the amount of skill required for the work,
- the permanency of the working relationship, and
- the degree to which the work is part of an integrated unit of production.
The evaluation of these factors is carried out on a case-by-case basis, ensuring a thorough examination of each individual's work scenario. The intent behind this meticulous analysis is to prevent misclassification and preserve the rights of workers.
Use an Employer of Record Service to Reduce Employment Risks
If you’re ready to venture down the road into the world of hiring independent contractors, I recommend partnering with an Employer of Record (EOR) service to guide you through this uncharted territory.
An EOR partner will help you mitigate the risks associated with hiring an independent contractor, and alleviate the potential concern of misclassification. This not only offers your organization peace of mind, but it also serves to reduce liability for issues like tax compliance, and labor laws.
However, it is essential to choose an employer of record service that is competent, trustworthy, and familiar with the laws and regulations of your specific field and area to minimize any potential risks of using an EOR service. This can help to further safeguard against potential issues, while also reducing administrative hassles and freeing up your internal resources for more strategic tasks.
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