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Employee vs. Contractors: Which Is Right for Your Business?

When it’s time to hire help in your business, you have a choice: hiring a part- or full-time employee or working with an independent contractor. It’s important to think about whether you need one or the other and classify them correctly.

Employee vs. Contractor: An Overview

When you hire an employee, you get more control over when and how that person works. You can train them to follow certain procedures, require certain hours, have them use your preferred tools and equipment, and have them agree to work only for you.

With independent contractors, you give up some of that control. You can assign duties, deadlines and expectations for the work you want them to perform, but you don’t control when or how they get the job done. An independent contractor sets their own hours, provides their own tools and equipment, and is free to work for others.

Compensation & Taxes

The distinction between employees and contractors is primarily a legal one, but it impacts how you pay them and how they pay taxes.

You may pay employees a salary or an hourly wage. Either way, you’re required to withhold federal (and sometimes state) income taxes and FICA taxes from their paychecks and pay federal and state unemployment taxes. In some states, you may also be required to purchase workers’ compensation coverage for employees. At the end of the year, you report the employee’s compensation and taxes withheld on a W-2.

You may pay independent contractors by the hour or a flat fee for services provided. You don’t need to withhold taxes (unless the payments are subject to backup withholding), provide workers compensation coverage or other employee benefits. 

Independent contractors make estimated payments of income and self-employment taxes. At the end of the year, you report payments of $600 or more to an independent contractor on a Form 1099-NEC.

Consequences of Misclassifying Workers

Hiring independent contractors is certainly simpler for a business owner. As long as you’re willing to give up some control over when and how the person does the work, you don’t have to deal with running payroll, withholding tax, paying for workers’ compensation, unemployment insurance or benefits.

However, Misclassifying employees and contractors can result in some serious issues with the Department of Labor (DOL) and the IRS. Besides owing back taxes to the IRS and penalties to the DOL, your business could owe state unemployment taxes, unpaid workers compensation premiums, unpaid overtime, minimum wages, unpaid vacation, and sick pay.

Worker Classification Tests

Unfortunately, there’s no one-size-fits-all answer for whether a worker is an employee or contractor. The IRS, DOL and state agencies each use their own tests.

The IRS test focuses on the degree of control the business has over the worker in three broad categories.

  1. Behavioral control

A worker is an employee if you can direct and control the work they perform. Examples of exerting behavioral control include providing detailed instructions on how the work is to be done, when and where to work, and where to purchase supplies.

  1. Financial control

A worker is an employee if you have a right to control the financial and business aspects of their job. Some factors to consider include:

  • Whether your business has invested significantly in the equipment they use
  • Reimbursing expenses – independent contractors are more likely to have unreimbursed expenses than employees
  • Opportunity for profit or loss – independent contractors may earn a profit or suffer a loss. Employees can only profit from their work
  1. Relationship

The IRS also takes into account how you and the worker perceive your relationship. Having a contract helps, although a contract stating the worker is an independent contractor isn’t sufficient on its own. Some other factors include:

  • Whether you provide benefits, such as health insurance, a retirement plan, vacation or sick pay
  • Permanency of the relationship – an expectation that the relationship will continue indefinitely, rather than for a specific project or period, is usually evidence of an employee-employer relationship
  • Activities – if the worker provides services that are a key activity of your business, this can be an indication that they’re an employee rather than a contractor

Bottom Line

If you’re considering hiring help in your small business, remember these three takeaways:

  • Hiring an employee gives you greater control over when, where, and how the work gets done, but there are also more long-term costs. Make sure you can afford these expenses.
  • If you hire an independent contractor, don’t treat them like an employee by providing them benefits, demanding they work certain hours or requiring them to work only for you.
  • Having a worker sign a contract that says they’re not an employee doesn’t necessarily make it so.

If you need help deciding whether to hire an employee or contractor, feel free to set up a call with me! I can help you review your goals and weigh the pros and cons.