Employee vs. contractor: How to make the right choice

It’s often obvious when a small business needs to expand its staff: It’s missing deadlines, paying more overtime, and getting poor online reviews. What’s not obvious is whether a new worker should be an employee or independent contractor. Yet knowing how each type of worker is different and when to pick one over the other can save money and prevent future problems.

What’s the difference between employees and contractors?

An employee typically works on-site at your business or with a designated schedule at another location, works set hours, and is compensated through your payroll system, which deducts contributions for Social Security, Medicare, unemployment, and employee benefits.

Independent contractors, on the other hand, are self-employed individuals who make their own hours and submit invoices for completed work. They are also responsible for doing their own withholding of income and payroll taxes, and usually do not receive company benefits. In many cases, they work off-site or hours that differ from your employees.

It’s important to understand how the IRS and state tax authorities define employee vs. independent contractor status. Otherwise, your company could be at risk of paying unexpected taxes and penalties. It could also face legal liabilities if a regulatory agency rules that a contractor at your business actually qualifies as an employee.

Generally speaking, government authorities look for three things in evaluating whether independent contractor status is warranted:

• Employer control over the person
• The contractor / employer relationship
• The economic realities involved

Let’s take a closer look at each of these.

Control test

The IRS views the degree of control you have over a contractor as a key driver of tax status. Control consists of either behavioral measures or financial requirements. For example:

• Behavior controls include giving contractors precise instructions on how to do their work or doing periodic performance evaluations. 
• Financial requirements involve reimbursing an independent contractor’s business expenses, paying for the person’s equipment, or restricting his or her ability to seek work from other clients, among other factors...

Relationship test

The IRS also looks at how the employer and independent contractor work together.

For example, having a written contract that explicitly defines a client / contractor relationship is helpful as long as it’s not just on paper. The IRS also looks for whether you are giving the person employee benefits, such as vacation or sick pay or pension or health insurance benefits. If you’re providing benefits, chances are the IRS will view your contractor as an employee.

Finally, a contractor who is considered an open-ended worker is more likely to be classified as an employee versus someone who is hired with a set start and end date.

Economic realities test

This test tries to determine the economics of the relationship. For example, it evaluates criteria such as:

• Is the contractor’s work integral to the business – that is, part of its primary work, rather than peripheral to it?
• Does the contractor have an opportunity to manage the profitability of his or her work? For example, does he or she make more money if the project is completed faster?
• How much skill and initiative does the contractor have? Contractors often have deeper and more specialized training and show more sales initiative than employees.

How to avoid employee misclassification

While the above criteria are helpful, there’s no cut-and-dry legal distinction between contractors and employees. Employment judges evaluate the facts in each case to make rulings. Still, knowledge is power when dealing with such matters. Consider taking these steps to make sure you are classifying new hires correctly:

• Seek IRS guidance. 
• Consult with a tax attorney.
• Ask the IRS to determine your contractor’s status by filing Form SS-8.

Finally, don’t let your need to reduce labor costs get you into trouble. As the owner of a small business, it’s crucial that you treat employees as employees. This involves:

• Complying with the Fair Labor Standards Act
• Remitting payroll and income taxes as required by the IRS
• Providing unpaid and job-protected leave under the Family and Medical Leave Act (FMLA)
• Offering benefits under your state’s workers’ compensation system

Failing to comply with these items may have serious financial and legal consequences. Adhering to the law will always be your best strategy.

Which to choose: Employee or contractor?

Employees are often more expensive because business owners owe payroll taxes on their wages. You also have to pay for workers’ compensation insurance and their employee benefits. However, saving money isn’t the only consideration. Hiring employees can also create more stability at your business and help you increase the core capabilities of your firm.

At the end of the day, deciding between an independent contractor and an employee hinges on your business requirements:

• If the work you need done isn’t permanent or closely tied to your company’s primary business or if you lack money to hire a permanent employee, consider going the independent contractor route.
• However, if the work is likely to continue indefinitely and is at the core of your business, it might make sense to hire an employee, even though it costs more.

What are the tax implications of hiring an employee vs. contractor?

The tax implications are significant for employees. You have to withhold, report, and remit an employee’s income tax withholding, Social Security and Medicare taxes, as well as pay unemployment taxes to your state labor regulator. None of this is required for independent contractors.

You also need to file different tax forms based on the type of role you are hiring. If you pay an independent contractor $600 or more in a tax year, you need to file a form W-9, as well as Form 1099-MISC. For employees, you must file a Form W-2 and withhold and pay taxes and benefits.

If you fail to classify an independent contractor properly, the IRS and state tax and labor authorities may attempt to collect what you failed to pay, plus penalties. It’s best to avoid this situation.

What are the insurance implications of hiring an employee vs. contractor?

Each worker type brings different insurance concerns:

• Your general liability insurance will cover you in case an employee injures a customer or damages someone else’s property. 
• If an employee makes a mistake that harms a client financially, then your e&o insurance or professional liability insurance will provide coverage for legal-related expenses. 
• Finally, hiring an employee means you must now pay for the person’s workers’ compensation insurance.

With independent contractors, you aren’t responsible financially if they get sick or injured on the job. However, you can be held liable for injuries or damages they cause to third parties while working for you. For this reason, it’s important to ask contractors to submit a certificate of liability insurance to confirm they have insurance coverage. Look for adequate general liability, e&o, or professional liability insurance limits. If there’s no existing coverage, consider finding another contractor.

What’s the bottom line?

As you consider hiring an employee vs. contractor to expand your business, remember these three takeaways:

• Hiring employees can add more stability and permanent capabilities, but also more long-term tax and employee-benefit costs. Can you afford these expenses?
• Don’t treat contractors as employees (paying them benefits, giving them office space, etc.)
• Don’t skimp on hiring employees when you have a strategic opportunity to grow your business.

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