How to Determine Whether to Bring on an Employee or Contractor

How to Determine Whether to Bring on an Employee or Contractor

As a busy business owner, you likely have experience hiring workers. Workers fall into two categories: employees and independent contractors. From tax treatment to hours worked, there are many differences between employees and independent contractors. In this article, we discuss those differences, and how to determine which type of worker is best for your business.  

What Factors Determine Employee Status? 

One of the most important factors to consider when determining if a worker is an employee is the degree of control the company has over the duties of the worker. Employees work for a single employer, and must follow their employer’s directions on hours of work, duties, and work location. Employees also have legal protections such as anti-discrimination laws and workplace environment regulations.  

What are the Characteristics of an Independent Contractor? 

Independent contractors are self-employed and often have several clients. They must provide their own tools, supplies, transportation, and other business needs when performing services. Independent contractors do not receive a salary, but invoice clients when jobs are complete. Independent contractors can choose hours of work, location, and projects. In a general sense, independent contractors have a much greater degree of independence compared to employees.  

Tax Differences Between Employees and Independent Contractors 

Employees receive W-2 forms from employers that provide details on wages earned and necessary withholdings. FICA (Social Security and Medicare) taxes are withheld from each employee’s paycheck. The employer matches the amount of FICA taxes withheld from the employee and sends the full amount to the government to cover FICA (Social Security and Medicare) tax payments. A portion of the employee’s paycheck is also withheld for state and federal income taxes.  

Independent contractors do not have any withholdings when receiving payment from clients. This is often why you hear independent contractors earn more for the same job than employees. Although no taxes are withheld from payments to independent contractors, independent contractors are still responsible for paying all required taxes. The self-employment tax is currently 15.3% (12.4% for Social Security and 2.9% for Medicare). Independent contractors must pay the required amount to the government and make estimated quarterly tax payments to ensure their tax payments are on track. Half of the self-employment tax amount is tax deductible.  

IRS Guidelines 

It is helpful to discuss the tests the IRS uses to determine if a worker is an employee or an independent contractor.  

The Relationship Test 

Independent contractors work according to explicit contractual agreements. The contract states hours, location, and job duties. Although the contractor must follow the terms of the contract, he or she is allowed independence on how to meet those requirements. Materials and supplies are provided by the independent contractor. The contract also defines how long the contractor works for the company.  

Economic Realities Test 

The economic realities test looks at the following factors: 

  • Is the contractor’s work integral to business operations? If so, this factor weighs in favor of classifying as an employee. 
  • Does the contractor control profitability? For example, will the contractor earn more if completing the job faster? If so, it is likely the worker is an independent contractor. 
  • How specialized is the job? Independent contractors often have more specialized knowledge than employees. 

Is Your Business Better Off With an Independent Contractor or Employee? 

Now that we have discussed the differences between an independent contractor and employee, let’s evaluate how to decide which is best for your business. Below is a decision matrix with common questions to ask when deciding between hiring an employee or independent contractor.  

  Yes  No  Notes 
Will I provide healthcare?  Employee  Independent Contractor   
Will I provide retirement benefits?  Employee  Independent Contractor   
Full-time, consistent work?  Employee  Independent Contractor   
Withhold FICA and relevant income taxes?  Employee  Independent Contractor   
Job-specific work, such as setting up software programs for first-time use  Independent Contractor  Employee  Employees can often perform these tasks as well, but it may be more cost effective to hire an independent contractor 
Will you supply work materials such as laptops, tools, or supplies?  Employee  Independent Contractor   

 The Importance of Correctly Classifying Workers as Employees or Independent Contractors 

Correctly determining if someone you hire is an employee or independent contractor is important. First, tax liability will be calculated correctly. For example, if a worker is improperly classified as an independent contractor and the employer does not withhold and remit the required FICA taxes, the IRS will enforce penalties on the company to recover the unpaid tax amount. There are relief provisions available to employers who have a reasonable basis for classifying workers as independent contractors rather than employees.  

Although there is no bright line rule for determining if a worker is an employee or independent contractor, evaluating the common factors will often lead you to the right answer. Factors including degree of control, consistency of work, and benefits provided often determine if an employee or independent contractor, and which is a better fit for your company. We hope this article has been helpful! 

If you are looking to have your 1099s filed for your independent contractors, due January 31st, please contact us today!

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