Contractor vs employee

The distinction between independent contractors and employees is one of the most important classifications in business. Get it wrong, and you face penalties, back taxes, and legal liability. Get it right, and you have flexibility, lower costs, and clearer relationships.

The core difference is control and independence. Employees work under your direction and control. Contractors work independently. But the details matter, and classification tests vary by jurisdiction. This guide covers the key factors, common tests, and practical steps to reduce misclassification risk.

Note: This is not legal advice. Classification rules are complex and vary by country, state, and industry. Consult an employment lawyer for specific guidance. This guide provides a practical overview to help you understand the basics.

Key differences at a glance

The control test

Control is the most important factor in classification. The more control you exercise over how, when, and where work is performed, the more likely the worker is an employee. The more independence the worker has, the more likely they're a contractor.

Behavioral control: Do you control or have the right to control what the worker does and how they do it? Employees receive instructions, training, and supervision. Contractors determine their own methods and processes.

Financial control: Does the worker have a significant investment in their business? Do they have unreimbursed expenses? Can they realize a profit or loss? Contractors typically have their own tools, bear business expenses, and can profit from efficiency.

Relationship type: Is the relationship ongoing and indefinite, or project-based with a defined scope? Employees have continuing relationships. Contractors work on specific projects with clear deliverables and end dates.

Common classification tests

Different jurisdictions use different tests. In the U.S., the IRS uses a common-law test focusing on control. Some states use the ABC test, which is more restrictive. Other countries have their own frameworks. Here are the most common:

IRS Common-Law Test (U.S.): Evaluates behavioral control, financial control, and relationship type. No single factor is determinative—authorities look at the totality of the relationship.

ABC Test (California, Massachusetts, others): To be a contractor, the worker must: (A) be free from control, (B) perform work outside the usual course of your business, and (C) be engaged in an independently established trade. All three must be met.

Economic Reality Test (U.S. Department of Labor): Focuses on economic dependence. Is the worker economically dependent on you (employee) or in business for themselves (contractor)?

International tests: EU countries, UK, Canada, Australia, and others have their own frameworks. Generally, they focus on control, integration, and economic dependence, but specific factors vary.

Red flags for misclassification

Certain practices increase misclassification risk. Avoid these if you want to maintain contractor status:

Setting work hours: Requiring contractors to work specific hours (9-5, Monday-Friday) suggests employment. Contractors should control their own schedule.

Providing equipment: Giving contractors company laptops, phones, or software licenses suggests employment. Contractors should use their own tools.

Ongoing work without defined scope: Contractors should work on specific projects with clear deliverables and end dates. Indefinite, ongoing work suggests employment.

Exclusive relationship: Prohibiting contractors from working for other clients suggests employment. Contractors should be free to serve multiple clients.

Integration into team: Including contractors in company meetings, org charts, or team-building activities suggests employment. Contractors should operate as separate business entities.

Paying hourly wages: Contractors typically invoice for deliverables or milestones, not hourly wages. Hourly payment suggests employment.

Reducing misclassification risk

To maintain clear contractor relationships and reduce misclassification risk, follow these practices:

Use clear contracts: Define scope, deliverables, payment terms, and IP ownership. Explicitly state that the contractor is an independent business entity, not an employee.

Define deliverables, not methods: Specify what you want delivered, not how the contractor should do the work. Let contractors control their own methods and processes.

Set project-based scopes: Structure work as specific projects with clear start and end dates, not ongoing indefinite relationships.

Let contractors use their own tools: Don't provide equipment, software licenses, or office space. Contractors should use their own resources.

Avoid setting hours: Let contractors control their own schedule. Focus on deliverables and deadlines, not when or where work is performed.

Maintain documentation: Keep records of contracts, invoices, deliverables, and communications. Good documentation supports contractor status if questioned.

When to use employees instead

Sometimes the work genuinely requires an employment relationship. If you need ongoing work, full-time commitment, integration into your team, or significant control over methods and timing, you need an employee, not a contractor.

In these cases, don't try to force a contractor relationship. Either hire the person as an employee directly (if you have a legal entity in their country) or use an Employer of Record (EOR) to employ them legally on your behalf.

The cost difference between contractors and employees is real, but misclassification penalties are worse. Classify workers correctly based on the actual relationship, not just cost considerations.

Penalties for misclassification

Misclassification penalties vary by jurisdiction but can be severe. In the U.S., expect to pay back employment taxes (7.65% of wages), plus penalties of $50-$1,000 per misclassified worker, plus potential state penalties and interest. Intentional misclassification can result in criminal penalties.

Beyond financial penalties, misclassification creates legal liability. Misclassified workers may be entitled to back benefits, overtime pay, and unemployment insurance. They may also have wrongful termination claims if the relationship ends.

The risk isn't just from government audits. Disgruntled contractors can file complaints with labor authorities, triggering investigations. Competitors can report suspected misclassification. The risk is real and ongoing.

Common questions

Can a contractor work full-time for one client? Yes, but it increases risk. Full-time work for a single client suggests employment. To maintain contractor status, ensure the contractor has other clients, controls their schedule, and works independently.

Does a contract determine classification? No. A contract is evidence of intent, but authorities look at the actual working relationship. If the contract says "contractor" but the relationship looks like employment, you're at risk.

Can I convert a contractor to an employee? Yes. If the relationship evolves and you need an employee, convert them. Either hire them directly (if you have an entity) or use an EOR. Don't maintain a contractor relationship when it should be employment.

What if the contractor wants to be classified as such? Worker preference doesn't determine classification. Authorities look at the actual relationship, not what the parties want. Both parties can agree to a contractor relationship, but it must match the legal definition.

The bottom line

Contractor vs employee classification is critical. The distinction affects taxes, benefits, liability, and legal compliance. Get it wrong, and you face penalties, back taxes, and legal risk.

The key is control and independence. Employees work under your direction and control. Contractors work independently. Structure relationships to match the classification you want, and maintain documentation to support it.

When in doubt, consult an employment lawyer. Classification rules are complex and vary by jurisdiction. This guide provides a practical overview, but specific situations require professional advice.