Employee vs Contractor

Understanding Independent Contractor vs. Employee Distinctions

According to the Internal Revenue Service (IRS), an employee is someone the company controls. Think of it like a conductor leading an orchestra. The company dictates:

• What's played—in other words, the tasks performed

• When it's played—in other words, the schedule

• How it's played—or the specific tools or methods used

Conversely, an independent contractor operates more like a soloist. They bring their specialized skills and set their own performance style, schedule, and methods to complete the project with minimal control exercised by the company.

Why Is This Important?

Employee misclassification can lead to a complex web of legal and financial problems in the future. You could face significant back taxes, hefty fines, and even lawsuits that could derail your startup's economic health. Additionally, there is a risk of reputational damage and a negative impact on employee morale. Here are some of the specific factors that determine worker classification.

9 Legal Considerations to Guide Your Employee Classification Process

These nine considerations will help you choose the proper classification for your new team member, whether hiring them to join your startup as an employee or as a freelance independent contractor to work on a specific project.

1. Behavioral Control

Do you set the worker's specific hours or require a uniform? Do you dictate the tools or software they use? Greater control over how the work is performed indicates a higher likelihood that the worker is an employee. Employees typically adhere to your directions and business policies and utilize company-provided equipment. Independent contractors bring their own expertise and equipment, setting their own schedules within the broader performance.

2. Financial Control

Do you reimburse the worker for travel or supplies, or do they cover these costs themselves? Do you offer benefits like health insurance, which is typical for employees? As an example, think of the orchestra's budget. Employees are paid a regular salary or wage, usually get benefits like health insurance, and the company usually covers reasonable work-related expenses. However, independent contractors are responsible for their business costs and are paid a set fee for the completed project.

3. Integration of Services

How essential are the worker's services to your startup's core operations? The core team for your startup plays essential roles, like performing marketing tasks or developing your product. Independent contractors, on the other hand, contribute specialized skills that complement your core business. Think of them as the guest composers who create a unique piece for your orchestra.

4. The Nature of the Relationship

Is this a one-time project or an ongoing position crucial to your company's day-to-day operations? Employees are hired for ongoing roles, becoming vital members of your startup team and continuing in their role as the company grows. Independent contractors are more like session musicians, brought in for specific projects with a clear start and end date.

5. Required Skill Set

Does the job require highly specialized expertise or a wider range of skills? Highly specialized skills—like composing a complex symphony—indicate that the creator is an independent contractor. On the other hand, employees may possess a broader range of skills applicable to multiple tasks within your startup, like a talented musician who can play multiple instruments.

6. Worker's Investment

Does the worker own and utilize their own tools and equipment, or do you provide them with company resources? Independent contractors, like freelance musicians, usually invest in their own instruments and equipment. Employees primarily rely on company-provided resources to perform their duties.

7. Financial Risk

Does the worker get paid a fixed salary or wage? Consider the financial risk to the worker. Independent contractors can make a profit or incur losses based on their performance and the project's results. Employees receive a fixed salary or wage, regardless of the project's success.

8. Right to Hire Others

Does the worker have the ability to hire assistants or delegate tasks to others? Independent contractors work solo, bring their employees, or hire assistants. Employees usually work within a team structure. Depending on their position, they may manage a team or have the authority to hire additional help.

9. Tax Forms: W-2s vs. 1099s

Finally, it is important to understand the tax implications of worker classification, as it can help avoid costly legal issues. Does the worker receive a W-2 or a 1099? Employees receive W-2 forms, which detail payroll or employment taxes paid by employers. You are responsible for withholding and paying the following on behalf of your employees:

• Social Security

• Medicare

• Unemployment taxes

• Applicable state taxes

For independent contractors, you issue 1099 forms, and they are solely responsible for paying their own self-employment taxes.

FAQs About Worker Classifications

A founders’ agreement isn’t just about splitting ownership; it’s about building a robust and well-oiled machine. Therefore, another section of the contract should explicitly outline what each owner is responsible for. This helps prevent confusion and ensures everyone is accountable for their specific area. For example, Founder A may be the marketing and sales whiz, while Founder B handles product development and operations.

Defining each founder’s roles and responsibilities sets the stage for a streamlined operation and offers several advantages:

• Sharp focus—owners can concentrate on their strengths, bringing their A-game to the tasks they’re best equipped to handle.

• Streamlined operations—clear roles prevent overlap and ensure a smooth workflow, keeping your startup running efficiently.

• Reduced conflict—defined boundaries minimize confusion and potential power struggles, allowing co-founders to collaborate effectively.

By clearly defining roles and responsibilities in your founders’ agreement, you’re setting your company up for success from the very beginning while fostering a collaborative and harmonious work environment. These clearly defined roles can be a magnet for investors and stakeholders who value a structured and effective leadership setup.

Can a Worker Choose Their Classification?

Unfortunately, no. The decision isn't based on what someone prefers but on the reality of the working relationship. Even if they agree to be an independent contractor, the law might still consider them employees based on the level of control your business has.

Can an Independent Contractor Become an Employee Later?

Yes. This can happen if the working relationship changes. Let's say you start by hiring a web developer as a contractor, but over time, you start providing them with a company computer, setting their schedule, and managing their tasks more closely. This shift in control could mean they're now rightfully considered an employee.

What If My Worker Has Both Employee and Independent Contractor Factors?

The IRS uses a common law test that weighs several factors, including control, financial arrangements, and the nature of the work. There's no single deciding factor. If you're unsure about someone's classification, it's wise to consult a lawyer or tax professional to avoid future issues. By considering these factors, you can confidently classify your new team member and ensure a harmonious working relationship.

Disclaimer: Bizee and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.