As a small business owner, you have two choices when hiring: an employee or an independent contractor. Do you know the difference? Determining the right fit for your small business will help you know what taxes need to be withheld and help you avoid legal trouble. Here are details that may be able to help you decide.
What is the definition of an employee?
An employee is a person whom you pay a contractually determined hourly or annual salary for their work. In most cases, an employee’s work tethers them to a certain schedule or location, though in industries such as construction, hours and location may vary.
Employees typically give you a completed IRS Form W-4 when they start working for you. This means employees are generally given a completed IRS Form W-2 by February 28 of the calendar year after the tax year in question.
Advantages and disadvantages of hiring an employee
You’ll often see the word “employee” used with no distinction between full-time and part-time employees. However, since full-time employees are more common than part-timers, the below list of advantages and disadvantages of when a worker is an employee refers solely to full-timers.
Typical advantages to hiring full-time employees:
Classifying a worker as a full-time employee may benefit your company in the following ways:
- Sense of commitment. Full time employees generally work 30+ hours a week and may be likely to have a long-term commitment to you and your business. Most people want job security, and workers who feel that sense of “home” often go the extra mile.
- Lower wages. The hourly wage for a full time employee is often much less since freelancers may charge a higher hourly rate. In fact, some companies struggling to stay in the black may lay off large numbers of employees and outsource these former employees’ work to independent contractors. This trend reflects that the average worker is generally paid less than the average freelancer.
- Easier delegation. Having a full time employee means you may delegate certain tasks to others, which may be helpful should you need to take some time away from your small business
- More control. Having an employee working alongside others during a set timeframe makes it easier to control what the employee does. This control applies both to the types of work performed and how the work is done. This degree of control may be especially important during periods when you’re striving for growth or struggling with revenue.
Typical disadvantages to hiring full-time employees:
There are certain requirements that come with having employees which include:
- Expectation of health benefits and vacation time. Most full-time employees will expect to be given a certain number of personal or vacation days. Increasingly often, the expectation is that employers should pay employees during vacation too. Additionally, the federal Affordable Care Act (ACA) mandates that companies with at least 50 full-time or equivalent employees offer health insurance to at least 95 percent of employees. This can mean additional expenses or labor and responsibilities you may not be ready to take on.
- Payroll taxes and benefits deductions. A full-time employee who earns $3,000 per biweekly pay period doesn’t necessarily take home $3,000 because federal and state taxes must be withheld, as well as any premiums the employee must pay towards their benefits. Doing so can be an error-prone and tedious process if you don’t use payroll software. And if you do start using payroll software, that’s another thing you’ll have to budget for.
- Regular pay periods. For employees, salaries need to be paid on a regular schedule, so you need to have a reserve of money in your bank account. If your business frequently struggles with cash flow, having employees is often among the quickest ways to wind up overdrawing from your account.
- Overtime pay. According to the Fair Labor Standards Act (FLSA), which the federal Department of Labor enforces, employees are entitled to overtime under certain circumstances. Non-exempt employees who work more than 40 hours during a given workweek must be paid time-and-a-half for all hours over 40. Some salaried office jobs are exempt from this rule, though almost all hourly employees are non-exempt.
- Workers’ compensation. In most states, all employers with at least one employee must provide workers’ compensation insurance. As an employer, you will be responsible for these plans’ premiums, though these payments may add up to less than the cost of an employee suing you over work-related injuries or illnesses.
- Paperwork and licensure. Additionally, specific payroll paperwork is legally required along with withholding your employees’ taxes, social security, and Medicare. Depending on your state, you might be responsible for your employees’ training and professional licensing requirements.
What is the definition of an independent contractor?
An independent contractor is a freelancer or sole proprietor who may have more than one client. (Freelancers and sole proprietors only meaningfully differ in that the latter can have employees and function as a business entity.) A worker is an independent contractor, as opposed to an employee, if you don’t withhold income taxes or other deductions from their paychecks.
You can also determine whether someone is an employee or an independent contractor based on when you pay them. Classifying a worker as an employee means you’ll have to pay them regularly, whereas independent contractors are paid only for the projects they are contracted for. This distinction also accounts for tax form differences between employees and contractors. We’ll explain this difference and several others below.
Differences between an independent contractor and an employee
The type of relationship you have with a worker may manifest in the below forms.
An independent contractor typically:
- Operates under a business name. A sole proprietor with employees generally has a company name. On the other hand, a freelancer who’s effectively, but not legally, an employee may work under their given name.
- Has their own employees. Although an employee can’t have employees of their own, some contractors have their own staff. Freelancers will generally be solo, but sole proprietors might bring a team with them.
- Maintains a separate business checking account. Employees earn most or all of their money from you and receive their pay with deductions withheld, thus, there’s little reason for them to have a separate business checking account. Independent contractors, on the other hand, must pay taxes separately and cover their own expenses (though many expenses are tax-deductible). Business checking accounts may make doing so easier.
- Invoices for work completed. Since you pay employees on a regular basis, they don’t need to invoice you to receive payment. The same can’t be said for independent contractors, who generally must invoice clients to get paid.
- Can have more than one client. Typically, a full-time employee’s only working relationship is with you. Independent contractors differ in that they’re essentially service providers, so just as your company has many clients, so do contractors.
- Has their own tools. Employees must work within your infrastructure, since you control their tasks and how they do their work. Contractors may do things their own way, with their own tools and infrastructures. They may need to adjust certain things to work within your systems, but for the most part, their work is autonomous.
- Sets own hours. Employees must work during the schedule outlined in their employment contract. Independent contractors, though, are their own bosses – you’re their client, not their employer. You thus have little to no control over their schedule.
- Keeps business records. Since independent contractors are essentially small businesses, freelancers and sole proprietors must keep extensive records of their income, expenses, and tax payments, whereasemployees' business records are generally recorded and retained by their employers. With the employee’s W-2 form provided by their employer come tax season, the income side of employees tax returns is pretty much covered.
- Signs a statement of work (SOW). Independent contractors forgo employment contracts in favor of SOWs that detail fees, payment timelines, and the work to be performed. You may want to sign these documents each time you assign a contractor work, or you may choose for one SOW to permanently cover all a contractor’s work.
- Receives IRS Form 1099-MISC for their tax returns. Form 1099-MISC indicates how much money you paid a contractor during a tax year. It includes no information about deductions since you don’t deduct anything from these workers’ payments. Contractors will use these forms to add up all their earnings for the year, and they’ll pay taxes based on this total.
- Qualifies for Paycheck Protection Program (PPP) loans. Since independent contractors effectively function as one-person businesses, they may qualify for PPP loans. These loans, which the federal government instituted in response to the COVID-19 pandemic, can be used to cover several types of operational expenses. Employees lack such operational expenses, during the course of their employment, so they can’t apply for PPP loans as an employee.
An employee typically:
- Performs duties dictated or controlled by others. Employers have full control over an employee’s tasks and how the employee completes these tasks. An independent contractor may choose which tasks to take on and may complete them using their own judgement.
- Is given training for work to be done. Hiring somebody for full-time work gives them a considerable amount of responsibility. Onboarding and training employees thus becomes necessary. Independent contractors, on the other hand, typically bring years of experience to the table, so they require little training and guidance. Therefore, the time and expense of training may be reduced or eliminated.
- Works for only one employer. The American standard for full-time work is 40 hours of work per week. Full-time employers typically demand this many work hours from employees, thus leaving employees less likely to work elsewhere. Instead, independent contractors source work from many clients to fill their time and increase their income.
- Has deductions taken from regular paychecks. Employment arrangements require that employers withhold income taxes and pay employees regularly. Many employers also offer benefits such as health insurance and retirement plans, and, in some cases, these benefits require additional paycheck deductions. Independent contractors generally do not have these deductions withheld.
- Receives form W-2 for their tax returns. Since you withhold taxes from employee paychecks, you must give them IRS Form W-2 during tax season. Conversely, independent contractors get Form 1099-MISC.
Advantages and disadvantages of hiring an independent contractor
Given the above distinctions between employees and independent contractors, some pros and cons of hiring contractors include:
Typical advantages of hiring independent contractors:
Small business owners typically prefer to hire freelance workers, and there are some distinct advantages to working with independent contractors.
- Less expensive. Although the hourly rate is usually higher, you’ll save money overall by not paying benefits or a regular salary.
- Easier termination. It’s much easier to stop working with an independent contractor that isn’t a good match than to go through the process of terminating an employee.
- Easier training. You can hire the right person for particular tasks as needed so you may not need to train them, and they are generally responsible for their own permits and professional licenses.
- Not subject to overtime pay laws. As explained above, the FLSA mandates overtime pay for certain employees. With independent contractors, overtime isn’t a concern.
- Requires no training. Independent contractors are service providers who bring their own unique skills and methods to the table. Therefore, they require minimal training or guidance. You may likely be able to hire them with the expectation that they get the work done properly, and in most cases, that’ll turn out to be true.
- Is paid irregularly with no deductions or taxes withheld. No, you can’t withhold a contractor’s pay or deduct anything from it, but you don’t need to plan for weekly, biweekly, bimonthly, or monthly payments. Instead, the contractor is to be paid by the due date on their invoice. You can set this date or let the contractor do so.
Typical disadvantages of hiring independent contractors
Downsides to using independent contractors may include:
- Lack of control. As a small business owner, you’ll lose some control over how tasks are performed, because you can’t closely monitor independent contractors' work. You can guide them, but usually, they aren’t on-site. The fact that they set their own hours may also prevent you from feeling a sense of control over the work being completed.
- Availability. If you find a contractor that you like, they usually work on a first-come, first-serve basis. This means they may not be available when you need them.
- Ownership. All copyrights will likely be owned by the independent contractor, unless you draft an agreement stating otherwise.
- Lack of long-term commitment. Independent contractors have many clients, so they’re less likely to feel long-term commitment to you than a traditional employee would. If they no longer enjoy working with you, they’re not bound to you in any way.
- Higher wages. Independent contractors typically demand more money for their work. After all, they’re essentially people standing in for full-on businesses. Hiring them can resemble the choice between bringing on an additional employee or outsourcing to a third-party firm.
- Delegation. Employment contracts mandate that, during work hours, employees take on whatever tasks you assign them, whereas independent contractors aren’t held to this same standard. Delegating extra work to them when you’re swamped may prove to be much tougher, if not impossible.
Factors to help in picking an employee or independent contractor
All the above comparisons between employees and contractors may seem like a lot, but they can also be condensed into four key factors. The following factors are vital when choosing between employees and contractors:
- Business size. A small business may not yet have the infrastructure to deduct payroll taxes or offer benefits. In these cases, a contractor relationship may be easier to maintain.
- Company culture. If your culture prioritizes having all hands fully on deck during work hours, you may prefer hiring employees. If flexible hours and employee freedom matter more in your culture, contractors may be better suited to meet these standards.
- Cost and budget. If most independent contractors would run you $50,000 over the year but you have an annual labor budget of $45,000, you might need an employee. If you instead have a six-digit labor budget, you might be able to afford one or even two full-time employees. And if you’re low on money for your labor budget, there are ways you may be able to get more funding.
How to get funding for hiring
Do you have a growing small business and need funds to hire? Visit the SmartBiz website to learn how SmartBiz enables businesses to pre-qualify in 5 minutes, get pre-approved in 30 minutes, and receive funds as fast as 7 days after the application is complete.
WHAT YOU NEED TO KNOW: The SmartBiz® Small Business Blog and other related communications from SmartBiz Loans® are intended to provide general information on relevant topics for managing small businesses. Be aware that this is not a comprehensive analysis of the subject matter covered and is not intended to provide specific recommendations to you or your business with respect to the matters addressed. Please consult legal and financial processionals for further information.