What is the difference between an employee and an independent contractor?
Takeaway: The distinction between an employee and an independent contractor is a critical legal test based on the degree of control you have over their work; misclassifying an employee as a contractor to save money can lead to severe tax and labor law penalties.
As you begin to build your team, you will engage with people in two primary legal capacities: as employees or as independent contractors. The difference between these two classifications is one of the most important and aggressively enforced areas of employment law. Intentionally misclassifying an employee as a contractor to avoid paying payroll taxes and providing benefits is a major compliance risk that can expose your startup to significant back-pay claims, tax penalties, and government audits.
Understanding the legal test that distinguishes an employee from a contractor is essential for building your team in a compliant manner.
The Core Test: The Right to Control
The fundamental difference between an employee and a contractor is not determined by the title you give them or the contract they sign. It is determined by the degree of control your company exercises over how they perform their work. The IRS and state labor agencies look at a wide range of factors to assess this "right to control."
Behavioral Control:
An employee is told what to do, when to do it, and how to do it. The company provides them with training, sets their work hours, and directs the specific methods they use to complete their tasks.
A contractor is hired to achieve a specific result. They are the expert, and they determine how they will achieve that result. You control the outcome, but they control the process.
Financial Control:
An employee is financially dependent on the company. The company provides their tools and equipment, reimburses their business expenses, and pays them a regular salary.
A contractor is running their own business. They use their own tools, are not reimbursed for their expenses, and are often paid on a per-project basis. They have the opportunity for both a profit and a loss.
The Nature of the Relationship:
An employee relationship is seen as being permanent or indefinite. They receive benefits like health insurance and paid time off. Their work is a core, integral part of the company's main business.
A contractor relationship is for a specific, defined project or period. They do not receive employee benefits, and their work is often on a peripheral or non-core part of the business.
Why Does Misclassification Happen?
Startups are often tempted to misclassify workers as contractors because it appears to be cheaper. When you hire a contractor, you do not have to pay the employer's share of payroll taxes (Social Security and Medicare), you do not have to provide benefits like health insurance or workers' compensation, and you have fewer administrative burdens.
However, the cost of being caught is far greater than the initial savings. If a government agency determines that you have misclassified an employee, you can be held liable for all the back payroll taxes, plus steep penalties and interest.
When you engage a service provider, you must make a careful, fact-based assessment of the relationship. If you are controlling the "how, when, and where" of their work, they are almost certainly an employee, and you must bring them onto your formal payroll to remain compliant.
Disclaimer: This post is for general informational purposes only and does not constitute legal, tax, or financial advice. Reading or relying on this content does not create an attorney–client relationship. Every startup’s situation is unique, and you should consult qualified legal or tax professionals before making decisions that may affect your business.