Who are you hiring? Contractor vs Employee

Most businesses need workers – not just owners – in order to function. When considering how you will add workers to your team, one of the first and most important decision you’ll need to make is whether you hire employees or contractors. The decision has legal and tax implications for the business and for the workers. This blog post will help you understand the difference between employees and contractors, how it can affect your business, and give you some insight into who (government!) cares if you do it wrong.

First, employees are people hired by a company to work in an ongoing relationship with the employer. Employees usually work specific hours, use the company's tools, and answer to their manager. They receive a regular wage or salary, tax withholdings, and often receive a variety of benefits. They are typically integrated into the company's structure and have little control over their work hours or how they perform their duties. Employees are often called “W2” workers as they receive a W2 tax document each year that contains their wage information that is reported to the IRS.

Meanwhile, independent contractors are, by definition, way more independent! They are typically paid per project, do not receive benefits, and are responsible for their own taxes. They are self-employed individuals or entities that provide services to a company. They maintain control over their work, decide their work hours, and typically offer services to multiple clients. Instead of sending a W2, businesses send contractors a 1099 that reports the money paid to them over the year.

Why should you care? There are very big differences in terms of the legal, tax and HR benefits that you can or have to offer workers, depending on their classification AND which state your business is in.

• Legal: When hiring an employee, businesses are subject to various labor laws and regulations such as the Fair Labor Standards Act (FLSA), Family and Medical Leave Act (FMLA), Occupational Safety and Health Act (OSHA), and more. These obligations encompass minimum wage, overtime, breaks, leave provisions, and safety regulations. For independent contractors, most or all of these regulations do not apply.

• Taxes: Employers are responsible for withholding income taxes, Social Security, and Medicare taxes for employees. For independent contractors, they only need to report payments to the IRS via Form 1099-NEC if they paid the contractor $600 or more in a year. The contractor is responsible for their own self-employment tax and income tax.

• Benefits and Insurance: Businesses are typically obligated to provide employees that work (usually 30-35 hours+) with benefits such as health insurance, retirement plans, paid leave, and unemployment insurance. Independent contractors are responsible for their own benefits and insurance.

Some states have very strict tests that evaluate whether a company’s workers are employees or contractors. If your business operates in California (or Massachusetts, New Jersey and others), your business falls under the “ABC” test which asks if:

A: The worker is free from control and direction of the hiring entity in connection with the performance of the work, both under the contract and in fact.

B: The worker performs work that is outside the usual course of the hiring entity's business.

C: The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed for the hiring entity.

All three must be true for the worker to be considered a contractor.

Finally, you should be aware that the government body that oversees the correct classification of workers in the United States is the Department of Labor (DOL), specifically its Wage and Hour Division (WHD). The Internal Revenue Service (IRS) also plays a significant role in worker classification, particularly when it comes to taxation issues. Both of these government bodies have oodles of information on their website that helps you understand your obligations as an employer.

Another reason you should care? Money! In terms of penalties for misclassification, they can be quite severe and encompass both civil and criminal penalties. Civil penalties vary by state, but at a federal level, the employer may be held liable for employment taxes for misclassified employees. They could also be liable for providing retroactive benefits, including health benefits, retirement savings, and unpaid overtime. In some cases, willful misclassification of employees can lead to criminal charges. The employer could face fines or imprisonment.

Typically, hiring contractors is cheaper, but not always better, and not always legal.