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Independent contractor vs employee: what you need to know

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This guide outlines the differences between an independent contractor vs employee, and how to protect your business when using an independent contractor agreement.

In terms of legal obligations, there’s a world of difference between an independent contractor and an employee. It’s important for both the business contracting the services and the independent contractor providing those services not to operate in a way that destroys this special relationship. 

If that happens, labor agencies might determine that the independent contractor is really an employee, who would be entitled to things like minimum wage, overtime pay, tax withholdings, workers’ compensation, and other employee benefits. 

To help avoid that outcome, we’ll explain key differences between an independent contractor vs employee. We’ll also provide some helpful information on structuring a good independent contractor agreement, including protecting the confidential and proprietary information of both parties. Finally, we’ll tell you how to make sure the service provider has proper insurance, including workers’ compensation insurance and commercial auto insurance for independent contractors.

Independent contractor vs employee: the differences

From a legal standpoint, it’s important to know the difference between an independent contractor vs employee. The confusion comes into play when the type of work is something that can be performed by either an employee or an independent contractor.

For example, let’s say a salon owner wants to hire stylists as independent contractors rather than as employees. Or a company wants to run its IT department through an outside IT consultant rather than staff an internal IT department. Often, companies try to hire workers as independent contractors rather than as employees to avoid the many legal obligations employers have to employees.

Employees are entitled to benefits such as minimum wages, overtime pay, workers’ compensation coverage, and income tax withholdings. Employees also enjoy the protection of federal, state, and local anti-discrimination laws.

By contrast, independent contractors are responsible for withholding their own income taxes and having their own insurance. Likewise, labor, wage, and employment laws don’t apply to independent contractors.

So when an independent contractor and an employee can perform the same or similar work, there are important distinctions that must be observed when hiring.

What is an employee?

An employee is a person who is hired by a business to perform certain duties directed by the company in exchange for wages or salary. Employees often enjoy benefits like paid time off, bonus eligibility, and 401(k) and pension plans.

When it comes to employee compensation, the company must withhold income tax, Social Security, and Medicare from paid wages. Federal and state minimum wage laws also govern how little employees can be paid, and make sure they are paid for all hours worked, including overtime pay.

Employees must comply with employee handbooks and other company rules and policies. There are also federal, state, and local employment laws enacted to prevent and punish discrimination and harassment in the workplace.

What is an independent contractor?

An independent contractor is an entity or person who provides services but is not directly employed by the company using the services. Many professionals, such as doctors, dentists, lawyers, accountants, contractors, and consultants in virtually every industry, offer their services for hire as independent contractors. 

In a true independent contractor relationship, the party paying for the service only has the right to specify the end result of the work, but cannot direct, determine, or control how the work will be done. For example, if a business hires a website design agency as an independent contractor, the business can specify the deliverables of a website and the required features of the website but cannot tell the web designer how to build the site.

The earnings of an independent contractor are subject to self-employment tax. The company using the services does not withhold income, Social Security or Medicare taxes from the compensation.

Businesses also do not provide employment-related benefits to independent contractors. There is no obligation to provide workers’ compensation insurance for independent contractors or the employees of independent contractors. Employment and labor laws also do not apply to independent contractors.

Establishing the independent contractor relationship

Some experts predict that companies in the future will have fewer employees and rely more on independent service providers to provide some of the core functions for the business. With the major shift from onsite working to remote working from home, companies are more likely to bring in external workers such as consultants, freelancers, and have each as an independent contractor vs employee.

To keep the independent contractor status of contracted service providers, it is important to follow established protocols regarding the relationship. That said, hiring contingent workers doesn’t have to be complicated. For the most part, it simply requires a good independent contractor agreement.

Define the relationship in the independent contractor agreement

First, a good independent contractor agreement will clearly define the relationship between the party using the service and the one providing it. This is necessary to avoid any claims that the independent contractor is really an employee, and thereby entitled to employee benefits.

To avoid uncertainty, it’s important to make clear in the written agreement that the service provider is not an employee, agent, or representative of the party hiring the service. It should also state that the independent contractor is a non-exclusive service provider, meaning that the service provider has other clients and does not work exclusively for the party hiring the service.

Furthermore, as mentioned above, when defining the scope of work or deliverables, the agreement should state that the independent contractor is solely responsible for determining how the services will be performed, and that the hiring party can’t control that. 

Assign Tax and Insurance Responsibilities

The agreement should make clear that the independent contractor is solely responsible for withholding and paying any federal, state or local income, Social Security, Medicare, unemployment, or payroll taxes.

It should also state that the hiring party has no obligation to provide workers’ compensation insurance or auto insurance for the independent contractor or its employees. Likewise, the company would want the independent contractor to agree to obtain this insurance.

The Duty to Protect Confidential and Proprietary Information

Even though independent contractors aren’t bound by a company’s employee handbook or policies and procedures, they do have a responsibility to protect the data and other confidential, proprietary business information of the hiring party. 

Confidential information means any data, information, or trade secret that is proprietary to the business and not known to the public. It can include strategies, plans, financial data, customer information, and any other data and information the business has spent time and effort to obtain and maintain.

The written independent contractor agreement should provide that any confidential information the independent contractor receives will be used solely relating to the services and for the benefit of the hiring party’s business.

On a related subject, scams and data breaches targeting companies are becoming increasingly common. Some data breaches are the result of human error by one or more employees or other professionals like independent contractors. For example, negligence might occur if an independent contractor accidentally sent the company’s database to an unauthorized email address or failed to password-protect documents containing private and proprietary data. A business may want to be protected against liability if a data breach occurs because of the independent contractor.

Insurance for an independent contractor vs employee

Employee insurance is a straighforward matter. But businesses need to make sure their independent service providers have the proper insurance, including commercial car insurance and workers’ compensation insurance.

What is commercial car insurance?

Commercial car insurance covers businesses that use vehicles to transport people or goods. A personal car insurance policy does not cover claims for cars used for business purposes. An independent contractor is responsible for anything it does with its vehicle. Even if an independent contractor uses a vehicle for client-related work, the client will not be liable for any claims or damages. 

A common mistake that independent contractors make is not purchasing the right car insurance. Without the proper coverage, the insurance company could refuse to pay a claim and leave the independent contractor open to a lawsuit.

Although there isn’t a specific independent contractor insurance policy, service providers should consider buying commercial coverage. Commercial car insurance provides peace of mind to independent contractors by covering accidents that happen in connection with the services or performance of the work.

What is workers’ compensation insurance?

Workers’ compensation, or workers’ comp for short, is a form of insurance for employers that provides wage replacement and medical benefits to employees who are injured on the job. These benefits are given in exchange for an employee giving up their right to sue the employer for negligence.

Each state has its own workers’ compensation laws to handle claims from employees who are injured while performing work-related duties. These laws are strict liability, which means that the employer can receive benefits regardless of whether the employee is at fault.

The company should make sure the independent contractor agreement addresses two important workers’ compensation issues:

  1. The agreement should state that the company does not have to get workers’ compensation insurance for the independent contractor or its employees. 
  2. It must provide that the company is not liable for any workers’ compensation claims brought by employees of the independent contractor.
Photo by ThisIsEngineering

About the author

Lauren Blair

Lauren Blair is a lawyer who writes and researches for the insurance comparison site, CarInsuranceComparison.com. She has over 25 years of experience in litigation.

 

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