Financials and Cash Flow

Employees vs. contract workers: What's right for your business?

There are distinct differences between full-time employees and independent contractors. Learn the differences between these two types of workers and how to determine which is best for your business.

Published: November 01, 2012
Updated: January 30, 2017

If your business is growing, you may be in the enviable position of needing to bring on more help. You're then faced with a choice: hire an employee or use a contract worker? Independent contractors are the traditional choice for projects or temporary work, while employees generally fill ongoing staffing needs.

Given the proliferation of online marketplaces for independent contractors, it may be tempting to staff up using contract workers. But in recent years, the Internal Revenue Service (IRS) and some state regulatory agencies have cracked down on the use of contractors for what are really employee positions.

If the IRS or state agency determines that a person was not really a contractor, but rather an employee under the law, stiff penalties can result. The IRS or state agencies may conduct audits to determine whether other workers are properly classified. These audits are not only time consuming but they may require your company to hire an attorney. And the final outcome may require your business to pay back taxes, penalties, interest and other charges.

Legalities aside, there may be other good reasons to hire an employee, rather than an independent contractor or vice versa.

To find out which is right for your business, ask yourself four questions:

1. Does the situation meet the IRS test?

According to the IRS' 11-point test, employee status is determined by who has the right to "control" the worker and the nature of the relationship. Here are a few of the factors the IRS looks at:

  • Behavioral control —  Under the relationship, does the worker have the right to decide how, when and where to do the work, which tools to use or where to buy supplies? Also, have you provided training? Independent contractors usually don't need training and have more control over their own work.

  • Financial control — Does the worker have unreimbursed business expenses? Is he or she free to offer services to others? Employees usually work exclusively for one employer and don't incur unreimbursed expenses.

  • Relationship — Is there a written contract describing the relationship the parties intended? Does the business provide employee-type benefits? How permanent is the relationship (indefinite versus a project)? Such factors suggest whether the relationship really amounts to employment versus contract work.

For more information on how the IRS distinguishes contracts workers from employees, see the full 11-point test on the IRS website.

2. How long will this worker be needed?

Independent contractors are the most flexible choice for short-term projects or temporary needs. As such, growing businesses may decide to use them for a few weeks or months until they know the volume will continue into the foreseeable future. Some businesses also use temporary contractors in a trial mode — eventually converting a high-performing temporary worker into a full-time employee. If a contract worker is still around after six months, however, you may want to consider replacing that temporary role with an employee position.

3. What skills are required for the position?

When you're in need of someone who has worked years to hone his or her skills, has deep knowledge and can hit the ground running, an independent contractor is often the best choice. If you hire an entry-level employee, they may not bring the same level of skill as the expert contractor and it may end up costing you more money to keep them on staff.

4. What's in your budget?

The costs of hiring employees versus contract workers are not as straightforward as they may seem. With employees, you're required to withhold and remit taxes to taxing authorities, pay for unemployment and workers compensation, and possibly provide other benefits. These costs can add up to 30 percent on top of the employee's pay.

With independent contractors, you avoid benefit costs. However, independent contractors are often just as expensive — if not more expensive — when you break down the total cost into an hourly basis. That's because independent contractors typically mark up their rates to cover their own costs of doing business and their benefits.

The hiring process is an exciting and rewarding time for many small businesses. Choose the structure wisely and you will be well positioned for the future.