Hire Contractors or Employees for Your Small Business?

Employees versus contractors—the choice is different for every small business. However, most small businesses rely on a blend of the two. Consider this: As of 2015, the U.S. Government Accountability Office found that 17.2% of workers were contractors. A small number of these workers (1.3%) were agency temps, while 3% were contract company workers, and nearly 13% were independent contractors who provided products and services to their client base. What’s more, with the rise of telecommuting and the increasing costs of healthcare, more workers are expected to join their fellows as contractors in the coming years.

However, let’s not discount the value of employees too quickly! Employees come with a number of advantages as well, which means that business owners are often faced with difficult choice when deciding between these two groups of workers. We’ll help you make this choice easier by showing you the difference between contractors and employees, how each group is taxed, and more.

Key Differences Between Contractors and Employees

Before you choose whether to hire a contractor or an employee, it is important to understand the differences between these two types of workers. In a nutshell, an independent contractor is a self-employed person that runs his or her own business, while employees are employed by your business. Here’s a breakdown of the differences:

Characteristics of Independent Contractors:

• A contractor maintains his or her own business, which entails advertising, invoicing, taxes, health insurance, and much more. All these things need to be factored into that contractor’s overhead when they present you with their rates.
• Contractors often operate under a business name. This isn’t always the case however — solo freelancers, like writers and artists, will sometimes operate under their own name as a self-employed person.
• Larger contractors are business owners just like you, which means they’ll have their own set of employees.
• Most contractors will have their own tools. For instance, an electrician won’t ask you to supply him with wire cutters and a writer will be equipped with the software necessary to get the job done.
• Contractors usually work for more than one person in order to make sure that their business stays stable and profitable. This means that they’ll often set their own hours, not only for flexibility, but so that they can schedule time for each of their clients’ needs.

Characteristics of Employees:

• Employees perform only one job rather than taking care of the business’ advertising or invoicing (unless, of course, that is their job), and they usually pay only a small portion of their health insurance, with the employer covering the majority of it.
• Contractors tend to complete jobs using their own methods, but employees are bound by the things that you dictate. They work in accordance with their job descriptions and stay within the boundaries set by your company’s operating procedures.
• Speaking of operating procedures, employees normally need to be trained in your company’s methods whereas contractors, as we stated above, have their own skillsets and operate by their own methods.
• Unlike an independent contractor, an employee works exclusively for you during the business hours that you’ve set.

Of course, the above characteristics aren’t always set in stone. For instance, you may give your employees flexible hours, or you may require that contractors follow your small business operating procedures. Because these lines can sometimes be blurred, the IRS has a few common-law rules that help you determine whether someone is a contractor or an employee:

• Most importantly, is your worker bound by a written contract or do they receive benefits like insurance or vacation time? If a person is bound by a contract, they’re definitely a contractor. However, contractors usually pay for their own benefits, so someone who receives benefits from your business (and isn’t bound by a contract) is an employee.
• When it comes to the cost of doing business, companies generally handle these costs by providing tools or reimbursement to an employee. Contractors, on the other hand, are responsible for these costs, so they will build them into the fee that they charge you.
• The final rule is easy: If your company controls a worker’s time and the way that they approach their job, this could be considered an employer-employee relationship.

Because the distinction between employees and contractors is often so unclear, the IRS has created Form SS-8, which is designed to help you determine the status of your workers. Even if you haven’t hired anyone for your small business yet, you can take a look at this form to gain a better understanding of the differences between employees and independent contractors.

Tax Requirements for Contractors and Employees

When working with contractors, your tax duties as a business owner are relatively simple: upon hiring the contractor, they’ll be required to fill out a W-9, which is basically a form that gives you the contractor’s correct name and tax identification number. After that, you’ll need to keep track of the money you pay to the contractor so that you can submit a 1099 form to both the contractor and the IRS in January. Note that you only need to submit a 1099 form if you’ve paid that contractor more than $600 during the year.

If you’re hiring employees, then your tax duties will be much more complicated. It starts with asking the new employee to fill out Form W-4. This form will tell you how much tax needs to be withheld from their wages, and you’ll need to withhold federal income tax, Social Security and Medicare taxes, unemployment tax, and any additional taxes that your state requires.

When the end of the year rolls around, you’ll need to furnish Form W-2 to each employee and to the IRS. This form lists the wages you’ve paid, tips, and other forms of compensation, and it also lists all the taxes you’ve withheld from an employee’s earnings.

Ramifications of Misclassifying Employees and Contractors

The idea of being in hot water with the IRS is a terrifying prospect for anyone, especially small business owners. If, however, you accidentally misclassify your workers, the consequences are unlikely to be the death of your small business. Here’s what to expect in various worker misclassification situations:

• If an employee is unreasonably classified as an independent contractor (that is, you have no valid reason for this person to be a contractor), then you may have to pay back the employment taxes that you should have paid for that employee.
• If a worker feels that he or she is an employee who has been misclassified as a contractor, they can fill out Form 8919, which reports uncollected Medicare and Social Security taxes to the IRS.

The nice thing is that there are provisions in place in case you misclassify workers—not that you should, but just in case you make a mistake. If you can prove that there was a reasonable reason to treat a worker as an employee and not a contractor, then you may be eligible for tax relief. In those situations, it is best to look at IRS Publication 1976 for eligibility requirements.

Deciding Between Independent Contractors and Employees

Now that you know the difference between contractors and employees, the tax responsibilities for each, and the consequences for misclassifying workers, how do you know what the right decision for your business is? It depends. You’ll need to make the choice on a case-by-case basis.

For some professionals, it is unlikely that you’ll need their services full time, and you definitely won’t want to be responsible for the tools and other things they need to do their jobs (this includes professionals like attorneys, plumbers, and electricians). In theory, you should only need these services once in a while, so you’re best off hiring as the need arises.

Here are some other factors to consider:

• Analyze costs carefully. In many cases, you’ll find that contractors are actually more cost effective despite the fact that their overhead is included in the fees that you pay simply because you’re not liable for taxes, benefits or equipment. Factor wages, taxes, benefits and all the other costs that come with employment and compare it to contractor rates.
• Think about how much time the job at hand will take. For instance, if you only need a social media manager to work on your marketing strategy for an hour or two per day, then a contractor might be the best choice. Similarly, if you have a relatively small number of employees, you might be able to outsource human resources tasks. If, however, your HR requires that someone is available at all times to attend to benefits questions, payroll and more, a full-time employee might be the better bet.
• Consider the length of time that you’ll need the employee. Things like seasonal work or one-time projects such as custom ERP software are best handled by contractors who expect to move from job to job. Permanent positions, however, are better filled by permanent employees.
• Think about the way your business looks to outsiders. If you’re constantly cycling through temporary contract workers to fill labor needs, you’ll have a high turnover rate which leads to a decline in the public perception of your company. Happy, loyal employees tend to spread the good word and make your company look great.

The choice between independent contractors and employees is yours and yours alone—and you’ll need to base your decisions on a variety of factors. If your small business is like most, you’ll likely end up with a good balance of both employees and contractors.