Business and Personal Finance: Employees Versus Contractors

Common Small-Business Tax Snafus – Employees Versus Contractors

One the biggest trouble issues facing new and small businesses is that of employees and independent contractors. It’s cheaper and easier to deal with contractors: you can hire them only as needed, they don’t get benefits, you don’t have to report or pay their payroll taxes, and you don’t have to go through the exhaustive regulatory procedures that come with employees.

Many new and small businesses choose to go the contractor route instead of hiring employees for those reasons, and several more. But the distinction can get tricky, especially when a contractor works only for your company or works out of your business location.


Some workers, called statutory employees, always count as employees no matter what. These employees include corporate officers who provide services for that corporation, food or laundry drivers, at-home workers given materials and requirements for performing work, full- time traveling salespeople who sell goods for resale, and full-time life insurance agents who work primarily for a single company.

The IRS watches this category pretty closely and reacts strongly to employees being misclassified as independent contractors (they don’t care so much if it goes the other way). State law gets into the act, too, with its own distinction between the two categories. The state laws and IRS rules are fairly clear here, making it easier to put everyone who works for you into the right categories. When you don’t, though, the consequences can be expensive.

Is Your Contractor an Employee?

When it comes to classifying the people who work for you, here’s the basic rule: unless you can prove otherwise, everyone’s an employee. It doesn’t matter if you have an oral agreement or a written contract; those don’t count as proof here. The combination of your state laws and the IRS rules for contractors has to be met, and you have to be able to show it.

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Although there are dozens of rules that govern this issue, they boil down a few basic ideas. First, you don’t treat contractors like employees: they get no training, no supervision, no instructions on how to do the job; they set their own hours; they could get someone else to do the work for them (a.k.a. a subcontractor); and they can do the work wherever they want to as long as they meet your deadlines. Second, true contractors tend to work for multiple clients, and work for each sporadically; in most cases, they offer services to the general public. That doesn’t mean you can’t use the same contractor over and over, but it has to be on an as-needed or on-call basis. Third, contractors are paid by the job, not by the hours they put in (although they are allowed to bill based on their hourly rate), and you don’t have to pay them if they don’t finish the job. They pay their own business expenses, file their own business tax returns, and can end up with either a profit or loss for their efforts. Finally, you can’t fire them; as long as they comply with your contract specifications, you’re stuck with them until the job is done.

The bottom line: the relationship has to be truly separate in order to prove that someone who works for you is a contractor rather than an employee.

Potential Consequences of Hiring Contractors

There are a lot of benefits to using contractors instead of hiring employees, but there are also some inherent risks:

  • Lawsuits: Employees file workmen’s compensation claims when they get injured on the job, but contractors may sue your company.
  • No control: You have no control over the contractor’s work, including missed deadlines or work quality; if you exert control, you have an employee.
  • Harder to sever: You can’t fire contractors; you can only breach your contract with them or sever the relationship after they hand you unacceptable work.
  • Government fines: If the government reclassifies your contractor as an employee, you’ll have a lot of taxes and fines to pay.
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Big Benefits with Contractors

With the potential risks you run when using contractors, it’s easy to forget the substantial benefits they can bring to new and small businesses. At the very least, there’s no long-term commitment; he comes in for one job, and you never have to use him again. There’s also no investment on your part: no employee search, no paperwork, no training—all things that take up your time and your company’s cash.

Then there’s the matter of payroll and everything that goes along with it. With employees, you have reports and tax returns to fill out and file, and tax payments to deposit. On top of that, you have to pay the employees regularly, and you also have to pay the corresponding employment taxes (an extra 7.65 percent of salary), unemployment taxes, and disability insurance.

With contractors, you avoid all the filing except one tiny form at the end of the year (IRS Form 1099), and you don’t pay anything but the agreed-upon price. Also, contractors don’t get benefits, such as health insurance and retirement plans, but you may have to offer those to employees to attract and keep the ones you want.

Finally, your company won’t be held liable for things the contractor does; it can, however, be held liable for things your employees do while at work. For example, if an employee drives your delivery van into someone’s living room, your company legally is financially responsible; if a contractor does the same thing with his delivery van, you may lose a customer, but you won’t lose anything else.

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