Independent Contractor vs Employee: Which is Best for Your Business?
Independent contractors represented almost 7% of the total workforce in the US, according to the latest figures from the Bureau of Labor Statistics. However, there's no doubt that this number has grown since that report was published in 2018. Companies that ignore this segment will reduce their opportunities for finding talent in a chaotic labor market.
So how do you determine if an independent contractor is right for your company? Understanding the difference between independent contractors and employees is the first step. Here’s how they compare and where you can go to learn more about the potential impact on your business.
What is an independent contractor?
An independent contractor operates as their own business and works independently – often for multiple clients. They are responsible for paying both halves of payroll taxes, both the employee’s and the employer’s (which the IRS considers “self-employment tax”). They also pay for the tools they need to perform their work.
Independent contractors are also known as "freelancers," “1099 workers,” or "sole proprietors." They’re not to be confused with “general contractors,” who oversee construction projects.
The term “gig worker” is also frequently used in this conversation. However, some independent contractors with established businesses and a handful of long-term, ongoing clients may find the term to be offensive and not representative of their work arrangements.
When a company hires an independent contractor to provide a service, you may do so directly. Or you may use an agency that acts as a go-between for a group of freelancers and the company hiring them.
The agency model has a few advantages over working one-on-one with an independent contractor, including simplified paperwork and payroll functions. Agencies have also made it easier for a business owner to reach labor or tax compliance benchmarks, for example when a contractor lives in another state or country.
What is an employee?
An employee is someone hired by a company, which directs the person on how to do their work. The employer usually has full control over the work as well as ownership of the work done, such as when an employee creates something, like documents, a video, or computer code.
A significant difference between employee and contractor arrangements is that employees generally work for just one employer in a full-time capacity. However, this is not always the case. They could work for more than one company, either full time or part-time.
Employees receive legal protections and benefits that independent contractors aren’t guaranteed. They also only pay the employee portion of the payroll tax. The employer pays the other half.
Is your worker an employee or independent contractor?
The IRS has published guidelines to help you determine whether you should classify a worker as an independent contractor or an employee. Note that these are separate from any state or local regulations, which may be more stringent in their interpretation. AB5 in California is one such example.
However, the spirit of the IRS law covers three main points to help figure out the level of control you have as a company when purchasing someone’s services. It is often referred to as an “ABC” test of the work performed.
A. Behavioral control
Behavioral control includes telling the worker what time they must work each day, how many hours they work in a week, and if they can use certain tools or methods. It also relates to whether they can do other kinds of work or have additional working relationships beyond their working relationship with you. If you control a worker significantly, the IRS may interpret this as “employment” rather than “contracting.”
B. Financial control
Financial control includes any money details where you tell a service provider how they can be paid, whether expenses are reimbursed, and what they can accept for a form of payment. If you set rates and aren’t open to negotiation, the IRS may perceive this as financial control.
C. Relationship control
Relationship control covers details such as the length of the business relationship, any included benefits, and the signed contracts. Under the current interpretation of the law, if a service provider does the same type of work that the company using their services provides, it may be seen as an employee relationship.
For example, a cleaning company that pays for the services of an independent housekeeper could be seen as creating an employment relationship. However, a real estate company that pays for the services of an independent housekeeper won’t be seen as creating an employment relationship because they specialize in two completely separate services (real estate vs. cleaning).
Relationship control gets even trickier with specific industries. Newspapers and magazines traditionally rely on freelancers to provide supplemental writing, editing, and photography, under an independent contractor relationship.
Is the writer providing the same services as the newspaper? Perhaps, but the newspaper or magazines are generally seen as media companies and therefore separate from writers. Interpretations of the law vary, especially on a state-by-state basis, so you should seek legal assistance if you are unsure where you fall in this spectrum.
Get more help from the IRS
The IRS advises companies to look at “the entire relationship, consider the degree or extent of the right to direct and control, and finally, to document each of the factors used in coming up with the determination.” If you need more information to make a decision, you can file Form SS-8 with the IRS to make a determination. Note that it may take up to six months to receive a reply.
Know the law
The IRS regulations are a good starting point for you to know how to classify your workers, but classification is just one aspect of compliance. You need to stay on top of several administrative and legal tasks related to each type of worker, and these tasks can change as a result of local, state, and federal legislation.
When you use contract labor, it usually has a very different workflow for compliance than hiring a traditional employee. You’ll need to consider the following:
- Employment eligibility (I-9 forms) for employees
- Social Security and Medicare tax withholding and employer payroll tax matching, as well as filling out of W-9 (for independent contractors) and W-4s (for employees)
- Benefits, including FMLA, workers compensation, and health insurance enrollment
- Tax reporting, such as creating and sending 1099-MISC/1099-NEC (for independent contractors) or W-2s (for employees)
- Equal Employment Opportunity regulations for people you hire as employees
This is not a comprehensive list of the paperwork needs of a contract worker vs employee. State and local forms and administration will help you figure out what you need to be compliant. Your state department of labor’s website is a good place to start.
Why does classification matter?
Classifying a worker incorrectly can have serious financial consequences for a company. The IRS may find that you should have paid payroll taxes for an independent contractor who should have been classified as an employee, and they will collect that money – plus fines and fees.
Your state department of labor or the US Department of Labor may also choose to act against employers who misclassify, leading to fines and requiring you to pay unpaid benefits and protections. It’s much less costly to do things right from the beginning, and it will save your small business from legal and financial headaches.
One way to reduce your risk when assessing 1099 vs employee hires is to contract with an agency. There are agencies for both employees and independent contractors, and most can tell you which will work for you. You’ll also reduce your administrative workload since they handle workflows for additional contractors and subcontractors.
Which is right for you?
Whether you hire an employee or independent contractor will depend on your answers to a number of questions, including:
- Is the position permanent or temporary?
- Do I need a lot of control over the workflow of the service provider?
- Will the person have access to confidential or proprietary information?
- Do we need an exclusive arrangement with the worker?
Aside from logistical details, there’s something to be said for how the relationship will affect the culture of your company.
Think about if you want to hire someone who will be a permanent part of your company. Do you want them to learn and grow with your team for the long term? If so, a full-time employee may be a better choice. If you want to finish a one-off task or service and don't need a fully invested worker, a freelancer may be a good fit.
Remember that the relationship goes both ways. You’ll need to invest more in an employee (financially and personally) than an independent contractor. In addition to onboarding, paperwork, training, and relationship building, employees have long-term financial and benefits requirements that you may need to fulfill even after they leave such as retirement plans and COBRA insurance.
If you are unsure which will fit your long-term needs, consider working with an experienced labor lawyer or HR professional.
Bottom line
Good help is hard to find, and the best person for the job may be either an employee or an independent contractor. Knowing which will fit into your scope is one consideration, but the legality of your choice may be the biggest deciding factor. So, how can you get started?
You may find that it’s helpful to research and network with other businesses in your industry to see what options they use and if they’ve run into difficulties with their choice. Use this as a starting point for your own research, however, because some businesses get it wrong – and it may be costly to follow their incorrect lead.
About the Author: Linsey Knerl is a contributing writer for HP Tech@Work. Linsey is a Midwest-based author, public speaker, and member of the ASJA. She has a passion for helping consumers and small business owners do more with their resources via the latest tech solutions.
