Contract employee vs permanent employee
A contract employee is different from a permanent employee, who may work full- or part-time, receive employment benefits, be entitled to protections under certain employment laws, and other key differences.
Every country defines contract employees differently, but generally, they’re self-employed individuals who are hired on a contract basis to assist with short-term projects. They should be paid per project rather than receiving regular paychecks, and they should have a special skill set to contribute that’s different from what regular employees do.
How to classify different types of employees
There are several different types of workers a company can hire based on their budget, projects, and other needs. Here’s a quick overview of some of the common types in the US:
- Full-time employees, sometimes called internal employees, work regular hours and are typically eligible for benefits such as health insurance, retirement plans, and paid time off. They often have employment contracts and long-term commitments to the organization.
- Part-time employees work fewer hours than full-time employees. They provide flexibility for employers and may be hired to fill specific shifts or roles on a temporary basis. They may receive benefits and may move to full-time roles if they desire.
- Temporary and seasonal employees are hired for a finite period to meet short-term staffing needs, such as filling in for absent employees, assisting with temporary projects, or working during specific seasons or peak periods, such as holidays or busy sales seasons.
- Independent contractors, also known as freelancers or contract employees, are self-employed individuals who provide services to clients under a contract. They have control over how they perform their work and are responsible for managing their taxes and benefits.
No matter what type of employee you hire, classifying them correctly is absolutely crucial. In the US (and most other countries around the world), it’s most important to correctly classify employees (whether full- or part-time) vs. contractors, since they have different tax treatment (more on that later in this article).
The Internal Revenue Service (IRS) uses three factors to determine whether a worker should be classified as an employee or an independent contractor:
- Behavioral control. Does the company control or have the right to control what the worker does and how the work is done? Or does the worker have control over their own business and when and how they work?
- Financial control. Are the business aspects of the worker’s job controlled by the company? This includes things like how the worker gets paid, whether they’re reimbursed for money they spend on their business, and whether they have their own equipment or if it’s provided by the company.
- Relationship type. What type of relationship does the worker have with the company? Do they get benefits? Is their relationship short-term or indefinite? Is the work they perform a key aspect of the business?
Department of Labor classification rules
Effective March 11, 2024, the Department of Labor released new rules for how to classify independent contractors under the Fair Labor Standards Act. Their rules include six tests you can use to determine if you have an employer-employee relationship with your worker that might indicate they’ve been misclassified. The tests are:
- Opportunity for profit and loss. Can the worker negotiate the price of goods and services and make business decisions that could result in profit or loss for their business?
- Investments by the worker and employer. Does the worker provide their own tools and equipment for the job?
- Degree of permanence. Does the work have an end date or is it indefinite?
- Nature and degree of control. Does the worker control when and how they work (i.e. do they work from home or are they required to use the company’s office space)?
- Whether the work is an integral part of the business. Does the worker perform work that’s central to a company’s core business function?
- Skills and initiative. Does the worker have special skills that employees within the company don’t possess?
What happens if you misclassify employees as contract workers?
Employee misclassification can come with serious penalties. The exact consequences vary depending on the legal jurisdiction, but in the US, classifying a worker as an independent contractor when they’re actually an employee risks:
- Back employment and taxes
- A $50 penalty per unfiled W-2
- A penalty of 3% of employee wages plus 40% of any unpaid FICA taxes
- A penalty of 0.5% of unpaid tax liability per month, up to 25% of the total tax liability
You may also be responsible for additional penalties for unpaid overtime pay, minimum wage law violations, and other state and local government and tax penalties.
