You need to hire someone. Maybe it is a developer to build your app, a designer to create your brand, a bookkeeper to manage your finances, or a sales rep to grow your client base. The first decision is not who to hire — it is how to classify them.
Get this wrong and you face IRS penalties, back taxes, state fines, and potential lawsuits. Get it right and you have a clear legal framework that protects both sides.
This guide helps you determine whether you need a contractor agreement or an employment contract, and walks you through what each should include.
The classification test: contractor or employee?
The IRS uses three categories to determine worker classification. Answer these questions honestly about the person you are hiring.
Behavioral control — how is the work done?
| Question | Contractor | Employee | |----------|-----------|----------| | Who decides the methods and processes? | The worker | You | | Who sets the work schedule? | The worker | You | | Who provides training on how to do the job? | The worker trains themselves | You provide training | | Where does the work happen? | Worker chooses | You specify | | Who determines the sequence and order of tasks? | The worker | You |
Financial control — how is the worker paid?
| Question | Contractor | Employee | |----------|-----------|----------| | How are they paid? | Per project, milestone, or invoice | Regular salary or hourly wage | | Who provides tools and equipment? | The worker | You | | Can they profit or lose money on the job? | Yes — they set their rates and control costs | No — they receive a fixed wage | | Can they work for other clients simultaneously? | Yes | Usually no (or restricted) | | Who pays for business expenses? | The worker | You |
Type of relationship
| Question | Contractor | Employee | |----------|-----------|----------| | Is there a written contract? | Contractor agreement | Employment contract | | Do you provide benefits? | No | Yes (or legally required) | | Is the work a key activity of your business? | Often no (support function) | Usually yes (core function) | | Is the relationship ongoing or project-based? | Project-based with defined end | Ongoing and indefinite |
Score yourself: If most of your answers fall in the "Contractor" column, you need a contractor agreement. If most fall in the "Employee" column, you need an employment contract. If it is a mix, err on the side of employment classification — the penalties for misclassifying an employee as a contractor are far more severe than the reverse.
What a contractor agreement must include
If the worker is a contractor, your agreement should cover these elements:
Scope of work
Define the specific deliverables, milestones, and acceptance criteria. The more specific, the better. Vague scope leads to disputes about what was promised and what was delivered.
- Describe the project, not a job role
- Include measurable deliverables with deadlines
- Define what "complete" means for each deliverable
- Specify the revision process and limits
Payment terms
Contractors are not on payroll. Define exactly how and when they get paid.
- Total project fee or hourly/daily rate
- Payment schedule (on completion, milestone-based, net-30)
- Invoice requirements and format
- Late payment penalties
- Expenses — which are reimbursable and which are not
Intellectual property ownership
This is where contractor agreements differ most from employment contracts. By default in many jurisdictions, contractors retain IP rights to their work unless the contract assigns those rights to you.
- Work-for-hire clause: Specify that all work product is owned by your company
- IP assignment: Explicitly assign all intellectual property rights upon payment
- Pre-existing IP: Contractors may use their own tools, libraries, or frameworks — define what they retain rights to
- License back: If the contractor retains any rights, ensure you have a perpetual license
Confidentiality
Contractors often access sensitive information. Include a confidentiality clause or require a separate NDA.
- Define what information is confidential
- Set the duration of confidentiality obligations (typically survives the contract by 2-5 years)
- Specify consequences of breach
Non-compete and non-solicitation
These are more limited for contractors than employees. Many jurisdictions restrict or prohibit non-competes for contractors entirely.
- Non-solicitation of your clients and employees is generally enforceable
- Non-competes must be narrow in scope, geography, and duration to be enforceable
- Check your jurisdiction's specific rules before including these clauses
Termination
Either party should be able to exit the relationship under defined conditions.
- Notice period for termination without cause (typically 14-30 days)
- Immediate termination for cause (breach, non-performance, illegal activity)
- Payment for work completed up to termination date
- Return of materials and confidential information upon termination
Create a contractor agreement →
What an employment contract must include
If the worker is an employee, your contract needs different provisions:
Job description and duties
Unlike a contractor's project-based scope, an employee's duties are ongoing and may evolve.
- Job title and department
- Core responsibilities and reporting structure
- Performance expectations and review schedule
- Whether the role is full-time or part-time
- Whether the position is exempt or non-exempt (affects overtime eligibility)
Compensation and benefits
Employees receive regular pay and may be entitled to benefits.
- Base salary or hourly wage
- Pay frequency (weekly, biweekly, monthly)
- Overtime policy (if non-exempt)
- Bonus structure (if applicable)
- Benefits eligibility (health insurance, retirement, PTO)
- Stock options or equity (if applicable)
Work schedule and location
Unlike contractors, employees typically follow your schedule.
- Expected working hours
- Remote, hybrid, or on-site requirements
- Overtime expectations and approval process
Intellectual property
Employment relationships typically give employers stronger IP rights by default, but you should still specify them.
- All work created during employment belongs to the company
- Invention assignment clause
- Prior inventions disclosure (what the employee created before joining)
- Post-employment IP obligations
Confidentiality and non-compete
Employees have broader confidentiality obligations than contractors.
- Comprehensive confidentiality clause covering all company information
- Non-compete clause (where enforceable — check your state; California, for example, largely prohibits them)
- Non-solicitation clause
- Return of company property upon termination
Termination
Employment termination is more regulated than contractor termination.
- At-will employment statement (if applicable in your state)
- Notice period for voluntary resignation
- Severance terms (if any)
- Grounds for termination with cause
- Final paycheck timing (varies by state — some require immediate payment)
The cost of getting it wrong
Worker misclassification is one of the most aggressively audited areas of employment law. Here is what is at stake:
IRS penalties for misclassifying an employee as a contractor:
- 1.5% of wages paid (income tax liability)
- 20% of the employee's share of FICA taxes
- 100% of the employer's share of FICA taxes
- These amounts double for intentional misclassification
State penalties (vary by state):
- Back payment of unemployment insurance premiums
- Workers' compensation insurance premiums and penalties
- Back wages and overtime for misclassified employees
- Some states impose per-violation fines of $5,000-$25,000
Lawsuits:
- Misclassified workers can sue for unpaid benefits, overtime, and damages
- Class action lawsuits are common when multiple workers are affected
- Legal defense costs alone can exceed the underlying tax liability
Quick decision flowchart
- Do you control HOW the work is done? → If yes, likely an employee
- Is the engagement project-based with a defined end? → If yes, likely a contractor
- Will they use your tools, work your hours, at your location? → If yes, likely an employee
- Can they work for other clients during the engagement? → If yes, likely a contractor
- Will you provide benefits or withhold taxes? → If yes, they are an employee
When in doubt, consult the IRS's 20-factor test or speak with an employment attorney. The cost of a consultation is a fraction of the cost of misclassification penalties.
Create the right contract now
Whether you need a contractor agreement or an employment contract, the most important thing is getting it in writing before work begins. Verbal agreements are nearly impossible to enforce and leave both parties exposed.
Hiring a contractor? Create a contractor agreement →
Hiring an employee? Create a service agreement →
Every contract generated by Contract.diy includes the clauses covered in this guide — IP ownership, confidentiality, termination provisions, and jurisdiction-specific legal requirements. Fill in your details and get a professionally drafted document ready for signatures in minutes.