Employee or Contract Worker | What Employers Need to Know
Employee or Contract Worker | What Employers Need to Know

Employee or Contract Worker | What Employers Need to Know

As a small business owner, there may be many factors to running a business that are new to you. Determining whether someone is an employee or contract worker is likely one of those things.

Knowing the difference between the two is something that is often looked over by business owners in favor of more pressing matters, such as labor laws and budgeting needs. However, not knowing how to classify someone that works for you can land you in hot water with the IRS, as different types of workers present unique tax liabilities to the employer.

In this article, we’ll show you how to avoid those issues by helping you to understand the difference between employees and contract workers and laying out the different tax liabilities each represents.

Employee or  Contract Worker

According to the IRS it is critical to classify your workers correctly. Both independent contractors and employees are people who work for a business to help it reach its goals. The difference between the two, however, lies in the business’s relationship with them.

What is a Contract Worker?

Contact Worker - Independant Contractor A contract worker is defined as person who work for a business under contract, whether that be written or verbal. Contract workers can also be referred to as independent contractors or freelancers. they can be self employed or work for a contracting agency.

They differ from employees in that they can work as needed rather than on a scheduled basis. They aren’t necessarily hired or fired but rather retained after each job until the business needs them again. Sometimes a contract employee will remain on with a company for a long time. 

What is an Employee?

Employee talking to boss Employees are those who are hired by a business and paid regularly. Employees are subject to certain labor laws as well, such as that they must actively work at least one day per month to still be considered employed with an entity (unless on medical leave). Independent contractors don’t face the same requirement.

How to Determine if Someone is an Employee or an Independent Contractor

There are very specific guidelines set forth by the government for business owners to use in classifying whether someone is a part-time or full-time employee or if they’re a contract worker.

Because of this, it is not up to the business to decide what someone’s work classification is. In fact, if you classify someone as the wrong thing, you can actually be penalized by the IRS—regardless of whether it was purposeful or accidental.

Luckily, it’s relatively easy to categorize your workers with the guidelines provided. Here are the three things you should be using to make your determination:

  • Behavioral: Do you have any degree of control over the work performed by the employee or how they go about doing it (i.e., how they get from point a to point b)?
  • Financial: Do you completely control the financial aspect of their duties, such as how the worker is paid, whether expenses are reimbursed, and who provides what tools?
  • Relationship: Do you maintain control over when the person must be working versus not? Do you provide them with employment benefits packages such as healthcare, worker’s compensation, or pension plans?

If your answer to the above questions was overwhelming, yes, then you have an employee. If not, they’re likely an independent contractor.

What Happens if I Misclassify a Worker?

Misclassifying one of your workers is detrimental to your business because of the way employer taxes work.

As you’re likely aware, there are three sets of payroll taxes for employees: medicare tax, income tax, and social security tax. These are grouped together and must be paid in two portions: the employee’s portion and the employer’s portion.

In short, each party pays half of the amount to the IRS to form the whole sum.

However, if you misclassify a worker as an independent contractor, neither of you is paying the appropriate employment taxes during the time they are employed. Then, because you can’t take those back taxes out of their checks, you’re then responsible for footing the entire amount.

As you can imagine, multiplying that across all of the employees under your control can result in a very hefty tax bill at the end of the year—and owing money to the IRS is not something you want to happen.

Workplace Differences Between Long-Term Employees and Contract Workers

There are several different laws that differentiate how an employee must be treated as opposed to a contract worker. For example, an employee:

  • Is covered by a wide variety of state and federal law
  • Is required to present certain information when hired, such as citizenship papers, identification, birth date, etc.
  • Files taxes at the end of the year using a form W-2
  • May earn an hourly rate or yearly salary
  • Must be paid using the same pay period each week/month

A short-term contract worker, however:

  • Is not affected by labor laws
  • Generally only interacts with the department they are working for and is not required to provide any identifying documentation by law
  • Reports payments greater than $600 on a form 1099 or form 1099-misc
  • Is generally paid a total sum for a project, whether that amount is calculated hourly, daily, etc. The payment terms are largely up to the contractor
  • Is paid by an accounts payable department once an invoice has been received


Being able to differentiate between an employee and an independent contractor is an important tool in any business for more reasons than one. Not only does having the ability to do so save you from a tax headache later, but it also helps you understand your responsibilities to the different parties you employ.

Additionally, knowing which is which will keep you safe in the event of an IRS audit, as you’ll have all of your documentation in line with the latest labor laws and regulations. This means you won’t have to worry about penalties, fees, or any sort of punishment as a result of misjudging your workers’ positions.

If you’re expecting an IRS audit or suspect you may have made a mistake in your employee/contract worker taxes, you should hire a qualified tax professional like Sherry Borshoff to help you get things sorted out.

Book a free appointment today and learn how Sherry’s tax consultant services can benefit you. You can trust Indiana’s Tax Expert!


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