Independent Contractor or Employee? How the Difference Affects Your Taxes

California’s rideshare and delivery drivers have been suffering from a bad case of whiplash (figuratively speaking) because lawmakers, judges, and voters disagree about their job classification. How it shakes out will affect how much they pay in taxes, along with other employment rights.

Many of these drivers started as independent contractors until 2019 when Governor Gavin Newsom signed into law California Assembly Bill 5 (AB5)(Opens in a new window), reclassifying them as employees. Then voters in the state passed Proposition 22(Opens in a new window) (58% in favor) in late 2020, which reclassified them again as independent contractors. Prop 22 also included a number of wage and labor policies, such as a 12-hour work limit during any 24-hour period, company-provided healthcare subsidies, and disability payments.

The following year, Alameda County Superior Court Judge Frank Roesch ruled that some elements of Prop 22 were unconstitutional(Opens in a new window) and that the measure was unenforceable. Proponents, specifically a coalition called Protect App-Based Drivers & Services, filed its own appeal of the judge’s ruling and presented a case in December 2022. The court is expected to rule within 90 days of that hearing. The case may eventually make its way to the California Supreme Court.

California’s current struggle is only one battle in the decades-long quest to determine the difference between independent contractors and employees, and how it shakes out could affect how you file your taxes and how much money you have to pay.

What’s the Tax Difference Between Contractors and Employees?

The distinction between the two worker classifications is critical. It legislates how income taxes are paid, for one thing, and how much someone pays. 

Employees receive an IRS Form W-4 before they’re paid for the first time so employers know how much money to withhold from each paycheck for federal income taxes and any applicable state and local taxes. Employers pay half of each employee’s Medicare and Social Security taxes (FICA). At the end of the year, employers prepare W-2 forms that go to the IRS and to each employee. These forms report wages and withholding. Employees must include this information on their income taxes on Form 1040.

Self-employed individuals, such as contractors, who make more than $400 during a tax year must pay federal, state, and local income taxes like employees do, but how they do it and how much they pay is different. They should receive a Form W-9 from any employer who plans to pay them more than $600 during the tax year, which verifies the independent contractor’s Taxpayer Identification Number (TIN) (usually a Social Security number). They must also pay self-employment tax(Opens in a new window), which gets reported in Form 1040 when they file their tax returns. That self-employment tax consists of Medicare and Social Security taxes and amounts to 15.3%. Since there is no other employer to pay half of this tax, the independent contractor pays the whole thing.

There are other forms that contractors and other self-employed people might receive instead of a W-2, including 1099-MISC, 1099-NEC, and 1099-K. When you file your tax return, income and business expenses are reported on Schedule C, which calculates the business’ profit or loss. If you have to file Schedule C, you may have to pay for a more expensive plan with an online tax service, as Schedule C isn’t always included at the lower tiers.

Since no one is withholding taxes for independent contractors on a regular basis, they’re expected to keep up by paying quarterly estimated taxes themselves. It can be difficult to estimate how much you should pay, but Form 1040-ES helps by providing a worksheet, tips, and vouchers to mail in with the payments. Contractors also have the option to submit payments online. Personal finance websites and small business accounting applications can help track income and expenses to make this job easier.

Failure to make estimated payments on the IRS’s schedule, or to pay enough, can result in a big bill at filing time, along with penalties.

Independent Contractor or Employee? Redefining the Classification

For more than 70 years, the US Department of Labor and the courts have used an economic test to determine whether a worker is an independent contractor or an employee under the Fair Labor Standard Act. Are the individuals “economically dependent on the employer” or are they in business for themselves?

That criterion is being revised and expanded. In October 2022, the Department of Labor published a Notice of Proposed Rulemaking(Opens in a new window) to modify that approach to classification in response to the 2021 IC Rule (i.e., the Independent Contractor Status Under the Fair Labor Act). It identified five factors(Opens in a new window):

1. The nature and degree of control over the work.

2. The worker’s opportunity for profit or loss.

3. The amount of skill required for the work.

4. The degree of permanence of the working relationship between the worker and the employer.

5. Whether the work is part of an integrated unit of production.

The Department of Labor has rescinded the 2021 IC Rule and suggested numerous modifications(Opens in a new window) to it that would reduce the risk of misclassification and be more consistent with the FLSA as judges have interpreted it. The comments period was closed on December 13, 2022, and the Labor Department is in the process of reviewing the comments. 

How the IRS Sees Independent Contractors vs. Employees

While worker classification remains in flux in California and other states (and the country as a whole), it’s certain that both employers and workers need to know how the IRS defines the classification. The tax obligations are worlds apart depending on whether someone is considered an employee or an independent contractor.

The IRS has its own guidelines(Opens in a new window) governing the differences between the two classifications. These standards relate primarily to the relationship between the two parties and the degrees of control versus independence. They fall into three categories.

1. Behavioral Control

What kind of instructions do employers give workers about their work? Does the employer control the details of workers’ performance? For example, what tools or equipment must they use? When and where do they do their work? What order or sequence do they need to follow? Such control would indicate that the individuals are employees. Independent contractors aren’t typically managed like this.

Employers are more likely to provide training to employees, whereas independent contractors tend to use their own methods.

2. Financial Control

Several questions can help you come to a conclusion here, including:

• How is the work paid? There can be a lot of overlap here. Employees typically receive an hourly wage or an annual salary, with opportunities for such extras as bonuses and commission. Independent contractors usually receive a flat fee or a time-and-materials payment, though they too are sometimes paid hourly.

• How much has the individual invested in facilities or tools? Independent contractors are usually on the hook for their own office space and the equipment and services they need to do their work. Employees have these needs met by their employer.

• Can the worker be open to the possibility of taking on other clients? This is generally frowned upon or prohibited in a contract for employees. Independent contractors can advertise and otherwise make their availability known.

• Does he or she have unreimbursed business expenses? Independent contractors are more likely than employees to have business expenses that they pay out of pocket and do not get reimbursed, though they can claim at least some of them as deductions on their income taxes. Employees don’t typically make purchases on behalf of their employers.

3. Type of Relationship

Does the employer provide the worker with benefits like health insurance, vacation and sick pay, and a pension plan? Benefits are typical of employer–employee relationships. Was the worker hired with the expectation that he or she would be employed indefinitely? This is more often true of employees. Independent contractors are often hired for a project or a specified length of time. Are the services provided by the individual a “key aspect of the regular business of the company?” If so, the employer would be more likely to control his or her activities, which would make the worker an employee.

How Employers Should Classify Independent Contractors

Employers have to weigh all of these aspects of employment in determining how to classify their workers. The IRS doesn’t have a magic formula for it, but says employers should consider the “extent of the right to direct and control the worker.” That seems to be the common denominator among all the classification tests of individual states, the Department of Labor, and the IRS.

Employers (or potential employees or independent contractors) who still have questions can file a Form SS-8(Opens in a new window): Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. The IRS says it can take up to six months to get a response. You could also contact a tax professional or labor lawyer for guidance. 

But do get it right. Companies have been known to—intentionally or not—classify individuals as independent contractors while requiring them to act like employees, since independent contractors can cost them significantly less money. 

Penalties for misclassifying workers can be severe. Diligent Delivery Systems, headquartered in Houston, recently had to pay a $5.6 million judgment(Opens in a new window) ($2.8 million in back wages and $2.8 million in damages) plus $150,000 in penalties to nearly 1,400 Arizona delivery drivers who were misclassified as independent contractors. 

So if you own a business, what should you as an employer do if you’re not sure how to classify a worker?

“Employers need to focus most on the factors that are common to all the tests and make sure, at a minimum, that you have these right,” says Sterling Miller, CEO and senior counsel at the legal firm Hilgers Graben(Opens in a new window).

To avoid misclassification, Miller suggests having a written independent contractor agreement and giving the individual the freedom to accomplish the job in the manner he or she sees fit. That way, the employer can worry about the result, not the “how.” Additionally, don’t treat independent contractors like employees. For example, don’t do performance reviews, invite them to employee meetings, or have them sign non-compete agreements.

“If you focus on the basics and you are truly engaging someone as an independent contractor, you should be fine,” he says.

For more tax tips and money matters, read our coverage of electric vehicle tax credits and how to get the most from your tax software.