Independent Contractor Agreement vs Employment Agreement: Key Differences

The distinction between an independent contractor and an employee is one of the most important classifications in employment and tax law. The type of agreement you use, an Independent Contractor Agreement or an Employment Agreement, reflects and reinforces this classification. Getting it wrong can result in significant tax liability, penalties, and legal exposure for the hiring party.

The Classification Question

Before choosing which agreement to use, you must determine whether the worker is properly classified as an independent contractor or an employee. This is not a matter of choice or mutual agreement. The classification is determined by the nature of the working relationship, and both the IRS and state agencies will look past the label on the agreement to examine the actual working conditions.

Calling someone an independent contractor does not make them one. Using an Independent Contractor Agreement for a worker who functions as an employee is misclassification, and it carries serious consequences.

IRS Classification Tests

The IRS uses a common law test that examines three categories of evidence to determine worker classification.

Behavioral Control asks whether the company controls or has the right to control what the worker does and how the worker does the job. If the company provides detailed instructions on when, where, and how to work, provides training on how to do the job, and dictates the methods and tools used, the worker is likely an employee. If the worker controls how and when the work is done, uses their own methods, and receives only the desired result specifications, the worker is more likely an independent contractor.

Financial Control asks whether the business aspects of the worker's job are controlled by the payer. Factors include whether the worker has unreimbursed business expenses, whether the worker has a significant investment in their own equipment or facilities, whether the worker makes their services available to the relevant market, how the worker is paid (hourly or salary suggests employment; flat fee per project suggests independent contractor), and whether the worker can realize a profit or loss.

Type of Relationship examines how the parties perceive the relationship. Factors include written contracts and benefits, whether the relationship is permanent or for a specific project, and whether the worker's services are a key aspect of the regular business of the company.

The ABC Test

Many states use a stricter test called the ABC test, which was established by the California Supreme Court in Dynamex Operations West, Inc. v. Superior Court (2018) and codified in California by Assembly Bill 5 (AB5) in 2020. Under the ABC test, a worker is presumed to be an employee unless the hiring entity demonstrates all three of the following conditions are met.

A: The worker is free from the control and direction of the hirer in connection with the performance of the work, both under the contract and in fact.

B: The worker performs work that is outside the usual course of the hiring entity's business.

C: The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed.

The B prong is the most significant change from the common law test. Under the ABC test, a software company cannot classify its software developers as independent contractors because software development is the company's usual course of business, even if the developers work independently and use their own equipment.

Tax Implications

The tax treatment of employees and independent contractors differs significantly.

Employees receive a W-2 form. The employer withholds federal income tax, Social Security tax (6.2%), and Medicare tax (1.45%) from the employee's paycheck. The employer also pays a matching 6.2% Social Security and 1.45% Medicare tax, plus federal and state unemployment taxes (FUTA and SUTA). The total employer-side tax burden is approximately 7.65% to 10% of wages.

Independent contractors receive a 1099-NEC form. No taxes are withheld. The contractor is responsible for paying their own income tax and self-employment tax (15.3%, which covers both the employee and employer portions of Social Security and Medicare). The contractor can deduct the employer-equivalent portion (7.65%) as an adjustment to income.

For a company, using independent contractors can appear to save 20-30% in labor costs compared to employees when accounting for taxes, benefits, and administrative costs. However, these savings are only legitimate if the worker is properly classified.

Benefits Eligibility

Employees may be entitled to a wide range of benefits depending on employer size, state law, and company policy. These include health insurance (mandatory for employers with 50+ full-time employees under the ACA), retirement plan participation, paid time off, workers' compensation coverage, unemployment insurance, family and medical leave (FMLA for employers with 50+ employees), and overtime pay under the Fair Labor Standards Act (FLSA).

Independent contractors are not entitled to any of these benefits. They are responsible for their own health insurance, retirement savings, and time off. They are not covered by workers' compensation or unemployment insurance. This is a significant difference in the total cost of the working relationship and in the protections available to the worker.

Liability and Insurance

Under the doctrine of respondeat superior, employers are generally liable for the negligent acts of their employees committed within the scope of employment. This vicarious liability means that if an employee causes harm while performing their job duties, the injured party can sue both the employee and the employer.

Companies are generally not liable for the acts of independent contractors. The contractor is an independent business and bears responsibility for their own actions. However, there are exceptions, including when the company retains significant control over the contractor's work, when the work involves inherently dangerous activities, or when the company is negligent in hiring the contractor.

Independent Contractor Agreements should include indemnification clauses and require the contractor to maintain their own liability insurance to protect the hiring company.

IP Ownership

Under the Copyright Act, works created by employees within the scope of their employment are "works made for hire" and are automatically owned by the employer. No special assignment clause is needed, though many Employment Agreements include one for clarity.

For independent contractors, the default rule is the opposite. The contractor owns the copyright in the work they create unless the work falls into one of the nine categories listed in the Copyright Act and the parties have a written agreement designating it as a work made for hire, or the contractor assigns the rights to the hiring party in a written agreement.

Independent Contractor Agreements should always include explicit IP assignment clauses and work-for-hire designations to ensure the hiring company owns the work product.

Termination Rights

Most Employment Agreements in the United States establish at-will employment, meaning either party can terminate the relationship at any time, for any reason (or no reason), with or without notice. Some Employment Agreements specify a term and require cause for termination, along with severance provisions.

Independent Contractor Agreements typically have a defined term or project scope and include termination provisions that may require notice, payment for work completed, and procedures for transition. Because the relationship is between two businesses, the termination is governed by the contract terms rather than employment law.

Misclassification Penalties

Misclassifying employees as independent contractors can result in severe penalties. The IRS can assess the employer's share of FICA taxes (Social Security and Medicare) on all wages paid, plus penalties and interest. The employer may also be liable for income tax withholding that should have been collected.

Under federal law, penalties include 100% of the employer's share of FICA, 1.5% of wages as income tax withholding penalty, 20% of the employee's share of FICA, plus accuracy-related penalties and failure-to-file penalties for missing W-2s and employment tax returns.

State penalties can be equally severe and may include back payment of unemployment insurance premiums, workers' compensation insurance premiums and penalties, back wages and overtime under state wage and hour laws, and fines per misclassified worker (California imposes $5,000 to $25,000 per violation).

State Variations

California's AB5 codified the ABC test and has the strictest classification standards in the country, though it includes exemptions for certain professions. Massachusetts, New Jersey, and Illinois also use the ABC test. New York uses a multi-factor test similar to the IRS common law test but applied more aggressively. Texas and Florida use more employer-friendly standards that closely follow the IRS common law test.

Key Takeaways

• The classification of a worker as an employee or independent contractor is determined by the working relationship, not by the label on the agreement.\n- The IRS common law test examines behavioral control, financial control, and the type of relationship.\n- The ABC test, used in California and other states, is stricter and presumes worker status as employee.\n- Employees receive W-2s with tax withholding; contractors receive 1099s and pay self-employment tax.\n- Employees may be entitled to benefits, overtime, and protections not available to contractors.\n- IP ownership defaults favor employers for employees and contractors for independent contractors.\n- Misclassification penalties can include back taxes, penalties, interest, and state fines.