Understanding the difference: independent contractors vs. employees

(Disclaimer: The information presented in this article is not intended as legal advice. Please consult with an attorney and/or tax professional before hiring independent contractors or employees.)

Just about every business needs outside help at some stage of growth, but how do you know if you need a contractor or an employee?

A few factors go into that decision — financial, cultural and even legal. Here’s an overview of what to consider when it’s time to build your team.

Get to know the differences

In the eyes of the law (and the IRS), workers traditionally fall into two categories: employees and independent contractors. 

These two types are often described by their respective forms for reporting income to the IRS: 1099 for independent contractors and W2 for employees. Both have their time and place for your business, and businesses frequently use both at the same time, depending on their needs. Below is a quick breakdown of the key distinctions.

  Independent Contractors (1099) Employees (W2)
What should they help with? Specific goods and services Any area of business
Should you train them? No Yes
Should you provide equipment? No Yes
Should they work under your supervision? No Yes
Who is responsible for withholding taxes? Contractor Employer
Should you provide benefits (PTO, health insurance, etc.)? No Yes

Contractors: a business within a business

Businesses often hire independent contractors when they don’t have enough work to justify permanent employees.

David Worrell
David Worrell

David Worrell is a fractional CFO and partner at Fuse Financial Partners. In his role, Worrell works with small and medium-sized businesses that don’t have a robust financial team. He said an independent contractor role is perfect for people you don’t have to supervise, such as consultants or housekeepers.

“1099 is designed as a way to employ experts,” Worrell said. “It’s designed as a way to employ people for their technical expertise or ability to complete a job that is not part of your day-to-day operations.”

This means independent contractors, similar to vendors, conduct business on a transactional basis. Usually, a business pays a contractor for his or her work and that’s it.

“You are buying a finished product or a finished service from those people,” Worrell said. “You’re not purchasing their time. You’re purchasing their output.”

In a sense, independent contractors are in business for themselves, meaning they carry their own liability and are responsible for their own taxes. They’re also expected to use their own tools.

“Technically, a 1099 contractor should bring his own computer and not report to your office every day to use your copy paper and pencils,” Worrell said.

And they can be an invaluable resource as you’re growing your business. 

The contractor cost/benefit analysis

Contractors will often command a higher wage, but could be cheaper in the long run, since they aren’t obligated to ongoing benefits in addition to their wages, as an employee would be. In addition, employers don’t have to pay for taxes for contractors — another source of savings.

“You don’t have to pay FICA, FUTA and SUTA on any 1099 contractors, and that’s equal to [approximately] 7-10% of your wage, so you can save a big penny there,” Worrell said.

There comes a time when it benefits the business to transition from contractors to full-time employees — although that moment can be hard to pinpoint. The cost savings can make it tempting for a business to rely too heavily on contractors, treating them more like full-time employees while classifying them as 1099’s. And that can get companies into trouble. After all, calling someone a contractor doesn’t necessarily make it true. The IRS has its own criteria for determining whether a worker is an independent contractor or employee.

Andrew Tucker
Andrew Tucker

Andrew Tucker is a fractional CFO and owner of AETucker Consulting. Tucker said he has helped clients decide between contractors and employees. In one instance, he advised a client to convert a contractor to an employee when the relationship didn’t pass the smell test.

“Basically, if the employee looks like and acts like an employee, then they’re probably an employee,” Tucker said.  

Employees: a long-term investment

Beyond the legal considerations, choosing between contractors and employees is also a cultural decision. Sometimes, it’s a smart move to fully commit to having a person on your staff, Tucker said. 

“In general, you’re going to get more loyalty, in my opinion, from an employee versus a contractor,” Tucker said.

Worrell agreed.

“As a business owner, the best way to build culture is always going to be to have an employee,” Worrell said.

Perils of Misclassification

Be careful of bending the rules – if you do, the potential penalties for non-disclosure could be as much as 40 percent of all wages for previous years.

If you find that you have made a mistake, you don’t necessarily have to wait to get audited to address it. The Voluntary Classification Settlement Program is an opportunity for business to come clean to the IRS and convert workers to employees for future periods, in exchange for a reduced amount in back taxes and penalties.

As of 2020, participants in the VCSP would pay “10 percent of the amount of employment taxes that would have been due on compensation paid to the workers being reclassified for the most recent tax year, calculated under the reduced rates of section 3509(a) of the Internal Revenue Code,” according to the IRS

“So many people get caught up in calling [employees] contractors, and they don’t realize it until it’s too late,” Worrell said. “It’s the right decision for you if you think you’re making incorrect classifications.”

You can outsource the decision, too

Rather than personally managing workers, some companies choose to farm out their HR functions by hiring a professional employer organization (PEO) or a staffing company. 

These companies can act as employers of record for you and handle all of the administrative workload, such as payroll, timekeeping and claims. They also have tremendous buying power for benefits, albeit at a cost to the customer.

“They can get preferred rates on your health insurance in particular,” Tucker said. “So instead of you having possibly 10 to 15 percent increases per year, you could have 3-5%, which could save a business a lot of money.”

Keep an eye out for changes

As the gig economy has taken root, some startups, such as Uber, have a business model that relies on a roster of independent contractors. That has implications on tax collection, because contractors can fail to self-report their income and that means lost tax revenue for states.

To address that shortfall, states like California have tried to reexamine the independent contractor role with legislation, Tucker said.

“They’re actually wanting people like Lyft and Uber drivers to be employees as opposed to contractors, and they very much changed the rules on that,” Tucker said. “So it depends on how many other states get involved with that same methodology.”

But chances are, they’re coming.

“Keep your eye out for future legislation from other states because I’ll bet there’s going to be some more.”

At the end of the day, how to hire is a complex decision, with multiple factors at play. Part of our goal at INCLT is to help founders and entrepreneurs build their business acumen so they can set their ventures up for success. That happens through these articles (thanks to our new friends at Kepler Team for supporting our efforts to spread valuable information), as well as through our Venture Mentoring Service, which pairs companies with seasoned business leaders from all areas of expertise.

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