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The difference between an employee and an independent contractor

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By Next Insurance Staff
Jul 30, 2020 min read

If you’ve been working for a while as an employee, you might be ready to start your own business as an independent contractor. It’s good to begin as an employee, so you can pick up skills and get more confidence in your abilities. As an employee, you have the security of a regular salary. You can concentrate on learning advanced techniques without having to negotiate with clients.

But now that you’re more experienced, you might be ready to take control of your own business. Perhaps it’s time to think about the difference between an employee vs. an independent contractor.

 

What is the difference between being an employee and being an independent contractor?

If you’re thinking of switching from employee to independent contractor, it’s important to understand the differences between them.

Legal status

There is actually a lot of legality that goes into defining the difference between an employee and an independent contractor.

These differentiators are both in terms of your rights relative any individuals or companies that you’re working with, as much as the IRS which will be taxing you directly if you branch out on your own.

Employee vs. independent contractor taxes

If you’ve ever been an employee, it’s likely that your employer took care of all your payments, including withholding from your salary for payments such as social security and income tax. This is particularly relevant when talking about taxes. When you’re an employee, you only pay 7.65% in social security and Medicare tax. Your employer pays a matching amount.

When working as an independent contractor, your fees from customers are a simple interaction, paid directly to you, in full, as per the invoice you’ve issued. As an independent contractor, you have to pay the full amount of 15.3% in social security and Medicare tax. You also have to pay your own unemployment tax.

As a contractor that means you’re now responsible for figuring out and paying on your own:

  • Income taxes, or in this case what is called the Self-Employment Tax
  • Social Security payments
  • Health insurance
  • Unemployment taxes

Since all these taxes can get a bit complicated, it’s often a good idea to work with an accountant on a monthly basis, or a tax advisor when you file annually. You can also consult our guide to paying taxes as an independent contractor.

Level of autonomy

The difference between being a self-employed contractor as opposed to an employee has a lot to do with the level of autonomy involved in your work. And this is defined by three main parameters:

  • Behavioral control – Does the company you’re working for control your time and how you allocate it? Are you subject to evaluation? Do you have to attend training? If so, you might be an employee.
  • Financial matters – As an independent contractor you should be able to work for as many people as you’d like, with no limitations set by a client. But other things that differentiate you from an employee who may be doing the same type of work are:
    • Expenditures on equipment (as a contractor, you generally cover equipment expenses while as an employee you can reasonably expect equipment to be provided)
    • Reimbursement (it’s unlikely your customer will cover your parking fees, but your employer might)
    • Manner of payment (employees have set, guaranteed wages per hour, week, or month; contractors negotiate per project or hour, and issue invoices)
  • Defining the relationship – This is a tricky matter. If a company gives you holiday gifts, invites you to its Christmas party, or in any way treats you as a member of the team, it may be creating what the law recognizes as employee status. That’s why a contract is always beneficial to both sides, stipulating the service, and clearly defined limitations to the relationship.

Employee benefits

As an independent contractor, you don’t get any employee benefits. You have to pay your own health insurance, and you don’t get any paid sick days or vacation days. Of course, the plus side is that you can take a day off when you need it, without having to explain to anyone.

Financial paperwork

When you’re an independent contractor, you’ll usually have to make estimated tax payments every quarter. That means more paperwork. You’ll also have to fill out a Schedule C profit and loss form, to declare profit or loss from your business.

Responsibility and liability

An independent contractor is responsible for the finished project. If the client isn’t happy, you’ll have to deal with it. You’re also liable for any business debt, mistakes, or accidents in your office or work site.

Insurance

If you’re an independent contractor, you’ll bear liability if someone gets injured, you make a professional mistake, or you break copyright. That’s why you need your own insurance for independent contractors.

Regular income

Your employee paycheck comes on the same date, every month, so you can build your budget around it. But independent contractors get paid when they finish the job, so your income could go up and down each month.

Risk and stability

Even if business is going badly, employees still get paid. But independent contractors risk making a loss. If you don’t get enough work, you still have to pay your fixed costs. You also might not make enough money to cover your expenses.

 

The benefits of being an independent contractor

Being an independent contractor vs employee can be very tempting. Here are some of the main benefits of being an independent contractor vs employee.

You get credit for your work

When you’re an employee and you do an awesome job, you get thanks from your boss. But if you’re an independent contractor who does awesome work, you’d earn more money. You’d get a reputation for excellent work, which would bring you more jobs. You’d be able to raise your prices too.

You’re in control

One of the biggest benefits to being an independent contractor vs employee is that you’re the one in charge. You can set your own hours. There’s no pressure to work overtime, and no boss telling you that you have to be at work by 9am every day.

You can earn more money

When you’re an employee, you can only earn your salary. You don’t really have the opportunity to raise your income beyond that. But as an independent contractor, there’s no limit to what you can earn. You can raise your prices and work more hours. If you hire your own employees, you can even work several projects at once.

You can pay less in taxes

Employees can’t claim business expenses as tax-deductible. But as an independent contractor, you’ll usually be able to claim all your business expenses and lower your final tax bill. That includes the cost of buying your tools, running a home office, marketing, and more. The tax benefits of independent contractor vs employee mean that you’ll usually pay less income tax.

 

Tips on switching from an employee to independent contractor

If you’ve thought about being an independent contractor vs. employee, and decided to make the change, congratulations! It’s a big step, so here are some tips to help you avoid some classic small business challenges.

  • Secure your finances. You’ll need to pay the startup costs for your business. That’s everything from buying tools and equipment to paying for your business license and insurance premium. Make sure that you have enough saved up to cover these expenses, or that you can get a small business loan.
  • Write a business plan. A business plan describes everything about your new business, like your expected expenses and income. You’ll need a business plan in order to get a business loan.
  • Create a marketing strategy. Before anyone can hire your business, they need to know that it exists. Think about how you’ll spread the word about the services you offer. Will you need a business website? Do you want to pay for ads in local papers, or focus on word of mouth recommendations?
  • Set up a time management system. When you’re an employee, you just have to focus on doing your job. But as an independent contractor, you’re in charge of the whole business. You have to write invoices, check your income and outgoings, and schedule projects, as well as doing the same work you did before. It can be hard to juggle all these different tasks, so create a time management system in advance to give yourself a head start.

Switching from employee to independent contractor brings new challenges and new opportunities. As long as you plan ahead carefully, you can succeed with your new small business.

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By Next Insurance Staff
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