What is a contract employee?


May 16, 2024

A contract employee is an individual hired by a company to complete a specific project or assignment for a defined period, typically under the terms of a written contract. Unlike regular employees, contract employees are often hired on a temporary or project basis and may not receive the same benefits or job security.

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:

  1. 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?
  2. 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.
  3. 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:

  1. 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?
  2. Investments by the worker and employer. Does the worker provide their own tools and equipment for the job?
  3. Degree of permanence. Does the work have an end date or is it indefinite?
  4. 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)?
  5. 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?
  6. 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.

Pros and cons of hiring contract workers

Pros of hiring contract workers

Cons of hiring contract workers

Flexibility: Contract workers offer flexibility in staffing levels and skills, allowing employers to scale resources up or down to fit their business needs.

Limited loyalty: Contract workers may lack loyalty to the organization and may prioritize their own interests over long-term company goals.

Specialized skills: Contract workers often bring specialized skills and expertise to projects, filling gaps in the existing workforce.

Reduced integration: Contract workers may feel less integrated into the company culture and may not have the same level of commitment as permanent employees.

Cost savings: Hiring contract workers can be cost-effective compared to hiring permanent employees, especially for small businesses that need help but can’t yet afford to hire a full-time employee.

Potential legal risks: Misclassification of contract workers or failure to comply with employment laws can lead to legal risks and financial penalties.

Common contract worker positions

Some of the most common positions for contract workers include:

  • Graphic designers
  • Writers and editors
  • IT consultants
  • Project managers
  • Marketing specialists
  • Software developers
  • Human resources consultants

Frequently asked questions about contract employees

What do you need to hire a contract employee?

Hiring contract employees typically requires less paperwork than onboarding full-time hires. However, there are still a few things you need:

  • A contract outlining the terms of the engagement, including the scope of work, compensation, duration, and other relevant details.
  • A W-9. Contract employees are responsible for paying their own income taxes. But employers still use W-9 tax forms to record all payments made to independent contractors.

If the contract worker will be handling any sensitive company information, you may also want to consider having them sign a non-disclosure or confidentiality agreement before beginning their work.

How do you pay contract employees?

Contract employees are often paid on an hourly, daily, or project basis, depending on the terms of the contract. Employers may use payroll services or issue payments directly to contract workers.

With Rippling, you can house individuals, sole proprietors, LLCs, and other types of contract workers, track their time, and pay them by the hour or at a set rate via direct deposit or check—even if they’re based in another country. And Rippling won’t take taxes out of their earnings, ensuring you stay compliant with IRS rules for contractors.

Do contract employees get benefits?

Contract employees typically do not receive employee benefits like health insurance, retirement plans, or vacation time from the employer. They also aren’t typically covered by minimum wage laws. Whether contractors are entitled to workers’ compensation coverage varies by state.

What taxes do you pay for contract employees?

Contract workers are treated like business owners, which means they pay self-employment taxes. In other words, they’re responsible for paying most of their own taxes, including income tax, Social Security tax, and Medicare tax.

Employers don’t have the same payroll tax obligations for contract workers as they do for regular employees—they aren’t required to pay tax withholding or unemployment tax for independent contractors like they do for their employees.

Disclaimer: Rippling and its affiliates do not provide tax, accounting, or legal advice. This material has been prepared for informational purposes only, and is not intended to provide or be relied on for tax, accounting, or legal advice. You should consult your own tax, accounting, and legal advisors before engaging in any related activities or transactions.

last edited: June 16, 2024

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The Rippling Team

Global HR, IT, and Finance know-how directly from the Rippling team.