Employees and contractors—they’re basically the same thing, right? Not really.
That’s like saying Superman and Batman are the same. Sure, they’re both caped crusaders, but while Superman uses his superpowers, Batman relies on his wits and smarts to fight crime.
Likewise, employees and contractors have distinct characteristics that set them apart from each other. And you need to know them, because there are serious consequences if you hire a contractor who should be an employee.
Here’s some information to know about hiring an employee versus a contractor to help you start thinking about which one is right for your business right now.
How are employees and independent contractors different?
They work differently.
Here’s a quick refresher on the definitions. According to the IRS:
- An employee is “anyone who performs services for you… if you can control what will be done and how it will be done. This is so even when you give the employee freedom of action.” What this means is that even if you allow someone to work with minimal supervision or oversight, if you want to tell them what to do and how, you’ll need to hire an employee.
- An independent contractor is a worker for whom “the payer has the right to control or direct only the result of the work and not what will be done and how it will be done.” In other words, when you hire a contractor you can only control the outcome or deliverable—not how the work is performed.
For example, if you hire a web developer to build a website, the result of the work is the website. You can dictate that you want a six-page website with unicorns and rainbows on it. Assuming the developer is an independent contractor, you cannot dictate that you want the developer to work every Tuesday for three hours, in your office, using your computer, following a specific workflow.
You pay them differently.
There are a few key differences in the way you pay a contractor versus an employee.
When you pay an employee, here are a few things you have to cover:
- Federal employer payroll taxes. These taxes amount to 7.65 percent of the employee’s wages and go towards covering a portion of their Social Security and Medicare.
- FUTA taxes, which is 6 percent of each employee’s first $7,000 in wages.
- State unemployment insurance (SUI), if required by your state.
- Any state and local taxes.
Other costs associated with hiring employees are:
- Benefits packages
- Overtime pay
- Worker’s compensation insurance
Whoa! That’s a lot of money to pay on top of employee wages. Is there another way? Well, yes: contractors.
Contractors are usually classified as self-employed individuals or individuals who are employed through another entity, such as an outside vendor, which means they are responsible for paying their own taxes. Unlike employees, who you split the tax burden with, when you pay a contractor you do not pay any payroll taxes.
Sweet! So why would I ever hire an employee?
Because, in the eyes of the IRS (and also in the eyes of state courts!), employees and contractors are not interchangeable. Each has its own legal classification, and if you hire someone as a contractor who should be an employee, you can get penalized and be subjected to retroactive payroll taxes and other costs. In other words, you will get in trouble and pay the government (and maybe even the individual employee in question) lots of money.
Keep in mind, just because someone agrees to be hired as a contractor does not mean they are legally a contractor. Recently, one of my clients was audited by her state’s employment agency. Even though all of her staff agreed to work as contractors and signed independent contractor contracts, they were still found to be employees.
The result? All staff had to become employees and she paid five months in back payroll taxes and penalties, totaling $15,000.
Finally, they can help you in different ways.
If you need help on a short-term basis or with work that supports your business but is not part of your core product or service, then you might want to think about hiring a contractor. Let’s say you run a fitness studio. Examples of contractors could be:
- Logo designer
- Monthly bookkeeper who works remotely
- Copywriter for a new website
- Photographer for headshots
Notice how all of these roles have specialized skills that fall outside of the operation of your business? And, with the exception of the bookkeeper, all of these examples are short-term jobs with a clear deliverable.
If you need help on an ongoing basis and with work that directly impacts the operations of your business, it might make sense to think about hiring an employee. Employees don’t just offer a single deliverable, but rather ongoing support. Examples of employees for a fitness studio could be:
- Administrative assistant
- Trainers who teach classes on an ongoing basis
Article Courtesy of Andi Smiles, Small business financial consultant, via our trusted payroll partner Gusto
Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties. Please contact your tax professional for advice.