It’s important to understand the difference
An employee is a worker who does a job defined by you. As their employer, you control what they need to deliver and how it should be done. While an employee might have some freedom (like flexible hours), you have the right to manage and direct them.
On the other hand, contractors are hired to do specific tasks needed by you or your business. These tasks are done without a permanent employment relationship. So while you specify the results of their work, they have more control over how the work is done.
The definition of an employee and independent contractor can vary depending on where you are based. The Department of Labor has specific legal guidelines about how you classify your workers. They can be a full-time employee and use a W-2 for tax purposes or an independent contractor and use a 1099 for tax purposes. Their classification affects their rights and entitlements at work. It also changes your responsibilities and obligations. Make sure you talk to your accountant, lawyer or a trusted employment expert if you don't know where to start.
Independent contractor or employee? Eight ways to classify workers correctly
Choosing the right type of worker can impact your entire business model. For example, Uber has built its business on hiring independent contractors.
Answer these questions to see if your worker is an independent contractor or an employee:
1. Is the person’s work an integral part of your company’s business?
If their role is essential to your business, they’re more likely to be classified as an employee.
2. Does the individual have a significant impact on the company’s profits?
If so, it’s likely they’ll be classified as an employee.
3. How does a worker’s investment in the company compare to yours?
An independent contractor works on a particular task or project. If a worker’s projects have a significant impact on the future of your company, it’s likely they’ll be classified as an employee.
4. Does the work require a special skill set?
If your worker provides a specialized or unique service, they may be an independent contractor. However, if the service or skills they provide are easy to replace, it’s more likely they’ll be classed as an employee.
5. What degree of control does the worker have?
A worker is more likely to be classified as an independent contractor if they can determine:
- their own hours
- where they work
- when they work
- a specific end date
6. Does the person provide regular and written progress reports to the company?
An independent contractor usually provides regular updates on their work and sends an invoice every week or month.
7. Does the person make their own self-employment deductions?
Independent contractors need to pay their own self-employment taxes such as social security and Medicare tax.
8. Does the person have more than one client?
An independent contractor usually has more than one client, as opposed to working with one company full-time.
If you’re unsure about your answers to these questions check with your lawyer, accountant or the IRS for more clarification.
Think carefully about what your business really needs
Most business owners want to avoid the extra cost of having a lot of employees, but some don’t have a choice. You’ll need to think about your situation to determine what’s best for you.
Hiring employees provides you with loyalty, certainty and continuity
Employees are more likely to have a long-term commitment to you and your business. The advantages of employees are:
- They get to know how your business works and can do their job without continual direction or further training
- Their wages tend to be less than a contractor because they have greater job security and often receive other benefits
- They’re always available when your business gets busy – you won’t need to race around looking for help
- You can take a vacation, knowing that someone is keeping your business running while you’re away
What to bear in mind if you’re hiring permanent employees
As an employer, you’re responsible for your employees’ training, professional development or licensing.
You also need to pay their wages or salaries on time, every time – even if your business has a quiet period. So you always need to have enough money in reserve to cover their pay.
With employees, you have specific legal payroll compliance requirements. You need to withhold your employees’ taxes and handle other deductions. All of this takes time, effort and money.
Independent contractors can provide you with flexibility, speed and choice
You might prefer to hire a contractor when you need help quickly. You’ll get someone with specific skills and expertise. And they’re responsible for their own training, development and professional licenses.
Although you usually pay more per job or per hour with a contractor, you could save money overall if you get someone who does the job efficiently. You’re not required to pay them any benefits and don’t need to commit to a salary.
If an independent contractor doesn’t work out, you’ve got no obligation to hire them again. But if you hire an employee, and need to let them go, it’s not always easy.
Don’t forget – contractors have downsides
While hiring independent contractors has its advantages, there are some drawbacks:
- You may pay more per hour or day for a contractor
- They have less company loyalty
- You may lose some control over how tasks are done
- You can guide them, but often they don’t work on site
- You might need a different skill set for the next project and need to find someone else
- If your workload increases, their availability isn’t 100 percent guaranteed
Understand how to classify your employees from the start
If you don’t properly classify a worker, you may be penalized, fined, or end up in court. If you think you’ve incorrectly classified a worker, you need to fix it as soon as possible. It’s always good to talk to your lawyer or accountant to get a second opinion.
Understanding the difference between independent contractors or employees can be complex. But getting it right will save you a lot of headaches in the future and may be one of the most important business decisions you make. So give your business a greater chance of success by hiring the right type of workers.
Disclaimer: Xero does not provide accounting, tax, business or legal advice. This guide has been provided for information purposes only. You should consult your own professional advisors for advice directly relating to your business or before taking action in relation to any of the provided content.