Contractor vs Employee: How to Get it Right

Mar 25

Helping small businesses make informed hiring choices.

As a small business leader, hiring help is an exciting step in the growth of your company, but this kind of growth also comes with important legal and financial considerations. One of the biggest questions you’ll face is whether to classify a worker as an independent contractor or an employee. The difference impacts everything from taxes to legal responsibilities, so it’s essential to know the difference so you can get it right.

What’s the Difference?

The main distinctions between an independent contractor and an employee comes down to control in the work and the relationship structure:

Independent Contractors: These workers are self-employed and provide services to your business for a designated period of time under a contract that sets the terms of the services they will provide. They control how and when the work is performed.

Employees: These workers are under your control—you dictate their working hours and how tasks are performed. Employees can accept an offer for employment, but in almost all states their employment is at-will, meaning the employee or employer can terminate the working relationship at any time. As an employer, you are also responsible for withholding taxes, providing benefits (as applicable), and complying with federal, state, and local labor laws.

Why It Matters

Misclassifying a worker can lead to serious penalties, including back taxes, fines, and even legal disputes. An investigation can happen due to a complaint by a current or former worker, or can be a part of a routine audit of your company’s finances by a federal or state agency.

Here are the key areas affected by misclassification:

Taxes & Payroll – Employees have payroll taxes deducted and paid for by their employer, while contractors handle all their own taxes and filings. Employers are responsible for Social Security, Medicare, and Unemployment taxes for employees.
Legal Protections – Employees are covered by labor laws, including wage and hour protections, and access to benefits like unemployment (if terminated) and workers compensation (if injured on the job). Most independent contractors are not protected or have to find their protections through labor unions/associations.
Control & Flexibility – If you need a worker to follow strict schedules and procedures, and provide extensive training and tools for them to do the work, they’re likely an employee. If you only need to dictate the end result, a contractor may be the better choice.

How to Determine the Right Classification

Federal government agencies, like the IRS and the Department of Labor, along with a number of state labor agencies (including in California, Illinois, and Massachusetts) use what are often called “ABC” tests when investigating claims in misclassification. Based on those tests, small business leaders should answer these questions when considering what type of worker to hire for their business:

Behavioral Control: Will you need to dictate how, when, and where the work is done?
Financial Control: Will you need to control the worker’s pay, reimburse expenses, or provide equipment?
Nature of Relationship: Will the work be long-term and essential to your business?
Skill and Training: Will you need to provide the training for this worker to perform the work?

If the answer is “yes” to most of these questions, the worker will likely need to be classified as an employee, and NOT an independent contractor.

How does that look in practice? This chart helps break down the difference between the two in greater detail.

    
    Independent Contractor
    Employee
  
    Work Schedule
    Sets their own hours
    Dictated by company
  
    Taxes
    All paid by contractor. The company provides a 1099-NEC to contractor for tax filing.
    Paid by employer + employee. Employer provides a W2 to employee for their tax filing.
  
    Work Equipment
    Provided by contractor
    Provided by employer
  
    Payments
    Hourly/Project based based in invoices and contracted schedule
    Hourly, salary, or commission (typically with a guaranteed minimum hours/rate) paid weekly, bi-weekly
  
    Benefits
    No/limited access to protective benefits: Unemployment or Worker’s Comp. Responsible for securing their own benefits (medical insurance, retirement etc)
    All statutory benefits provided by employer (unemployment, worker’s comp) and optional additional benefits (health insurance, retirement, professional development, etc)
  
    Work Protections (Compliance) 
    none/limited depending on local laws
    Employer must adhere to federal and local labor laws (termination, harassment prevention, overtime pay, minimum wage etc).
  
    Work with Others
    Typically work with multiple companies/clients
    Work for only one employer (full-time employees)
  
    Professional Development and Training
    Self-funded and maintained
    Provided by employer

Making the Right Choice

In general, if you need ongoing, dedicated help and want control over how work is performed, hiring an employee might be best. If you need specialized help for a project that is outside of your main business function (i.e. hiring a plumber or an accountant for your lemonade making business), a contractor could be the right fit.

When in doubt, consult an employment attorney, HR professional, or an accountant to ensure you’re making the correct classification. Getting it right from the start will save you headaches—and potential fines—down the road.