Launching a small business carries many complex decisions. As you explore possible branding or business structures, consider who will support your business and how. Consider whether you’re prepared to tackle the responsibilities of becoming an employer.
Two avenues can help you get the practical support you need: hiring traditional employees or working with independent contractors. This decision is far from simple: it impacts everything from payroll to taxes and even legal liability.
Misclassification could lead to huge penalties, so, if you opt to work with independent contractors, take extra steps to show compliance. Clarify employee vs independent contractor before hiring workers.
What is the difference between an employee and an independent contractor?
Employees and independent contractors both provide labor in exchange for compensation. They complete essential workplace tasks, using their talent and expertise to serve customers or clients, all while helping employers reach their business goals.
This is where the similarities end. Employees follow strict schedules and policies and receive considerable guidance from employers. In return, they receive consistent wages and benefits. Independent contractors maintain greater control over how and when they work, but receive fewer protections.
How the IRS determines employee vs independent contractor status
The IRS clearly defines employees and independent contractors, using strict criteria to determine how various workers are classified.
No single factor can definitively determine employee vs contractor. Instead, the IRS aims to capture the big picture of the working relationship. These factors clarify independence in their various forms:
Behavioral control
This category reveals whether (or to what extent) employers can direct or control workers. This distinction often centers around instructions: which tools to use or how to sequence tasks, for example. Employees may receive detailed instructions or may be evaluated on how the work is performed.
Training is a strong indicator of traditional employment. Independent contractors, however, are trusted to use their own approach.
Financial control
While both employees and independent contractors could potentially invest in equipment or incur expenses, this is more common among independent contractors. Independent contractors can also increase their earnings based on their workload. They are often paid flat fees, although some set hourly rates. Traditional employees earn regular wages on an hourly or weekly basis.
Relationship type
Perceived relationships can influence worker classifications. These relationships can even override written contracts. For example, workers hired with the expectation of continued employer-contractor relationships may actually qualify as traditional employees. A lot depends on whether services play a central role in determining how the business is run.
Independent contractor vs employee: Key differences at a glance
Professionals experience the differences between independent contracting and traditional employment on a daily basis. This determines, for example, how they are paid and how much autonomy they enjoy.
In other situations, the difference between employee and contractor may be more apparent to the businesses that rely on workers’ talents or services. Key distinctions include:
- Schedule control. Employers determine which hours employees work. Independent contractors are allowed to set their own schedules.
- Tax withholding. Employers withhold taxes on behalf of employees. Independent contractors handle (and pay) their own taxes.
- Benefits eligibility. Employees may receive benefits such as health insurance or retirement contributions. Independent contractors are not eligible for these benefits.
- Tools and equipment. Many employees use tools or equipment provided by their employers. Independent contractors supply their own tools or equipment at their discretion.
- Risk of profit or loss. Employees earn predictable hourly or weekly wages. Independent contractors may see higher profits or could lose money depending on their workload or expenses.
- Legal protections. Employees are protected by a wide range of employment laws that generally do not apply to independent contractors.
Tax implications for contractors vs employees
With traditional employment, tax burdens largely fall on employers. The reverse is true when independent contracting is involved. Businesses that work with independent contractors pay agreed-upon rates, leaving the cost and burden of taxes resting squarely on the shoulders of their contractors.
For employees
When businesses classify workers as employees, they take on several tax obligations that do not come into play for independent contractors. Essentials include:
- Withholding federal and state income taxes from paychecks. Employees complete the IRS W‑4 to determine how taxes should be withheld based on dependents or filing status. Employers then handle withholdings so that taxes are paid throughout the year and not in a lump sum.
- Contributing to taxes under the Federal Insurance Contributions Act (FICA). Covering Social Security and Medicare, FICA allows employers and employees to contribute to programs that fund retirement, healthcare, and disability benefits. Employers pay a share and withhold a matching share on behalf of employees.
- Paying federal and state unemployment taxes. Responsible for unemployment insurance contributions, employers fund benefits to help workers who lose their jobs.
- Issuing annual W-2 forms. Every year, employers provide W-2 forms that summarize what workers earned and how tax contributions were withheld. This form helps employees file accurate tax returns.
For independent contractors
Businesses are required to issue 1099-NEC forms on behalf of contractors who earn over $600 per year. They do not, however, withhold taxes or cover payroll tax contributions.
Independent contractors must pay their own federal and state income taxes. Because they are treated as businesses for tax purposes, they pay self-employment taxes that cover both the employer and employee portions of Social Security and Medicare.
From the business perspective, tax obligations may seem straightforward when working with independent contractors. There’s a major caveat, however: misclassification could lead to penalties or back taxes. It’s essential to fill out (and issue) the right forms and to classify workers accurately from the get-go.
Risks of misclassifying a worker
The potential for misclassification (and the harsh consequences that ensue) can outweigh the short-term conveniences or savings of working with independent contractors. Risks include:
- Back taxes or benefits. Employers may be required to cover all unpaid Social Security, Medicare, and income tax withholdings if the IRS determines they should have previously contributed these on behalf of misclassified workers. They may also need to cover overtime or account for minimum wage shortfalls.
- Penalties. Employers may be assessed federal or state fines on top of back taxes, potentially tens of thousands per misclassified worker.
- Potential lawsuits. Misclassifications may result in legal action, including class-action lawsuits that can result in significant settlements.
Misclassification is often accidental but, given the huge consequences, it’s worth taking extra steps to prevent it. This can be avoided through accurate documentation and by issuing the correct tax forms.
How to properly engage an independent contractor
Working with an independent contractor can be helpful if you need specialized assistance and cannot commit to hiring a long-term employee. To prevent the consequences of misclassification, follow these best practices:
Use a written contractor agreement
Written agreements set the stage for strong working relationships with independent contractors. These agreements clarify the following:
- Scope of work. Agreements should outline the type of work contractors are expected to complete. Include deliverables to help both the business and contractor understand the nature of the work.
- Payment terms. Rates, payment methods, and invoicing schedules should be detailed, but confirm that independent contractors manage their own billing and set their own rates.
- Independent status. Contractor agreements should confirm that independent contractors maintain autonomy.
Keep in mind that this contract cannot guarantee independent contractor classification; if worker treatment mirrors that of a traditional employee, the IRS will still classify workers as such, regardless of what the written agreement contains.
Maintain independence in practice
Independent contractors should be free to work when and how they see fit. Maintain independence by allowing contractors to set their own schedules and use their own equipment.
Set clear expectations for desired outcomes but don’t dictate the methods used to arrive at those results. Avoid impressions of exclusivity; contractors should understand they’re free to work with multiple clients.
Complete proper tax documentation
Businesses should encourage independent contractors to complete W-9 forms and confirm that all information shared on these forms is accurate.
Is it better to be an employee or an independent contractor?
There is no ideal arrangement for every business or professional. A lot depends on personal preferences and operational needs. Many businesses work with both independent contractors and employees, as different tasks may call for different schedules or different forms of oversight.
From the worker’s perspective
Traditional employment promises stability and predictability. Employees receive consistent income and benefits and may also enjoy professional development opportunities.
Independent contractors may lack stability, but they gain flexibility and autonomy. These workers set their own hours and choose projects or clients they find compelling. By adjusting their rates or working with clients, they can quickly grow their income. However, some of these earnings must be set aside to cover taxes and business expenses.
From the business owner’s perspective
Small business owners rely on independent contractors to cover gaps in expertise. These contractors offer flexibility for project-based work and may also limit overhead. Employees allow businesses to maintain greater control and oversight but prompt higher payroll costs.
Ultimately, the role itself (and the control needed to ensure it’s performed correctly) should determine whether a worker is classified as an employee or an independent contractor.
How to decide which classification is right for your business
Choosing between employee and independent contractor begins with fully understanding the nature of the role.
Be sure to clarify: is the work central to your business? If a particular area demands ongoing support or expertise, focus on traditional employee arrangements. If the role in question is strictly temporary or highly specialized, an independent contractor may be preferable.
Review IRS guidance closely to confirm that the professionals who support your business qualify as employees. If you feel unsure about classifications, seek support from consultants or other experts.
Setting up payroll and compliance properly
Once you’ve decided whether to hire employees or independent contractors, take steps to fulfill tax obligations and prevent misclassification.
- Register for state employer accounts. Official registrations allow businesses to withhold state employee taxes and make state unemployment insurance contributions. Complete registration forms and set up payroll systems accordingly.
- Obtain an EIN. The Employer Identification Number (EIN) is needed whether you ultimately issue W-2 or 1099 forms.
- Separate business finances. Keep personal and business funds separate to maintain clean records and to streamline tax reporting. Consider using a dedicated business bank account or a separate business credit card.
- File tax forms on time. Avoid penalties by submitting W-2 and 1099 forms on time and by establishing (and following) deposit schedules.
Although early efforts involving formation and form submission can be helpful, these will not handle payroll; ongoing reporting should be expected. Still, LLC services from platforms such as Tailor Brands make it easier to fulfill these reporting requirements by helping business owners get organized. Relevant services include LLC formation and EIN assistance.
Conclusion
Worker classification can make a huge difference in your journey as a small business owner. If you’re still learning how to start a small business, understanding the difference between employees and independent contractors is an important early step. There’s no right answer to the independent contractor vs employee debate, just the right choice for your business.
Think carefully before pursuing either avenue, considering what type of support you need and how much control the work in question requires. Evaluate all potential working relationships and document them carefully based on IRS guidance. Don’t hesitate to seek help as you get started or as you tackle ongoing reporting requirements.