Independent Contractor vs. Employee: A Business Owner’s Guide

The growth of the contingent workforce since the pandemic has created a flurry of new talent options for businesses. As more people choose to work as independent contractors, companies can save money on hiring, recruiting, and employment costs while still accessing deep expertise in a particular field.

When deciding between an employee or an independent contractor, you may have questions like these:

• What are the differences between an independent contractor and an employee?
• Which option is right for this role?
• How do I know I'm classifying this worker correctly?
• How do I pay a 1099 worker?

Here's what you should know.

What Is an Independent Contractor?

Independent contractors, including freelancers, contingent workers, and consultants, are self-employed individuals who provide specific services for an agreed-upon fee and during a particular time frame.

According to IRS guidelines, an independent contractor is someone who has the right to control when and how they complete work. No employer-employee relationship exists, and the contractor maintains responsibility for their schedule, client list, fees, and tax obligations.

Independent Contractor Examples

Independent contractors are most likely to work in arts and design, media, personal care and services, construction and building, and grounds, cleaning, and maintenance roles. Common jobs include:

• Journalist
• Graphic designer
• Freelance writer
• Social media manager
• Photographer
• Fitness coach
• Roofer
• Truck driver
• Building contractor
• Fractional service provider

What Is an Employee?

An employee is generally economically dependent on an employer for work and wages. The employer determines the hours worked, sets the schedule, and provides direction on how the work should be completed. An employee may be full-time or part-time, or even seasonal or per diem, and can be protected by federal, state, and local employment laws.

Employee Examples

Roles like the following are typically filled by an individual classified as an employee:

• Executives
• Directors, managers, and supervisors
• Strategic planners
• Retail salespeople
• Cashiers
• Office managers
• Call center representatives
• Customer service specialists

What Are the Differences Between an Independent Contractor and an Employee?

For federal tax purposes, the IRS uses a test that considers behavior, financial, and relational factors to determine whether a worker is an employee or an independent contractor:

• Behavioral: Does the business control how and when the worker does their job?
• Financial: Does the business control when and how the individual is paid and which expenses, if any, are reimbursed by the business?
• Relationship type: Does the worker have a written contract or receive benefits such as sick leave, paid vacation days, or health insurance? Is the relationship ongoing or finite in length?

Tests under the National Labor Relations Act, Title VII of the Civil Rights Act, the Fair Labor Standards Act, and other federal, state, and local laws also offer guidance to help you correctly classify workers when applying those laws. Worker misclassification can result in significant violations and penalties under applicable laws from enforcing agencies, so be sure you understand all the applicable requirements.

Here are some of the potential differences that may exist between an independent contractor and an employee:

Advantages and Disadvantages of Using Independent Contractors

In an increasingly competitive labor market, independent workers can help you fill talent gaps without the expense of hiring a full-time or part-time employee, depending on the amount of control you intend to give that worker.

Advantages

Engaging an independent contractor can benefit you in several ways:

• Cost savings: Independent contractors can deliver quality work at a fraction of the cost of hiring a full-time employee. These cost savings can be significant, especially for unique or complex skill sets.
• Access to specialty expertise: Independent contractors often differentiate themselves by becoming proficient in niche markets. They can give you access to unique expertise and proficiency that your team lacks.
• Increased bandwidth: If you face an impending deadline for a specific task or significant project, a contractor can relieve pressure on your team and help you stay on track.

Disadvantages

Not every situation is a good fit for an independent contractor. Sometimes, you need an internal team member to meet the needs of the situation. Here are some disadvantages of working with a contractor in these cases:

• Lack of company knowledge: Some jobs require knowledge of your internal processes, culture, or teams that a contractor lacks.
• Decreased control: Businesses have less control over when and how a contractor works than they do for an employee. If you need someone to be available or on call during business hours, a contractor may not be the right choice.
• Risk of misclassification: Misclassifying workers as independent contractors when they should be considered employees (or vice versa) could result in steep penalties. Classification can be tricky depending on the worker's specific responsibilities, which can put you at risk of mistakes.

How To Engage an Independent Contractor

Engaging the services of a 1099 contractor involves different processes and paperwork than you would use for hiring an employee. Consider these 5 areas.

Contract or Agreement

Independent contractors often work under contract agreements. Most contractors will ask you to sign a contract before beginning work, but you may also want to maintain your own independent contractor agreements. The contract should cover the project's scope of work, pay rates, payment terms, confidentiality, start and end dates, and a statement of independent contractor status.

Tax Implications

You should not withhold any taxes from a contractor's wages. Contractors pay taxes directly to the federal government, and businesses don't have to match any of their Social Security or Medicare taxes as they would with employees.

Additionally, businesses typically do not owe unemployment taxes for these workers.

Tax Forms

Rather than filling out a W-4 form as an employee would, independent contractors should complete and submit Form W-9. This form documents the contractor's name, address, and taxpayer identification number. It should be kept on file for at least 4 years in the event of an IRS audit.

Contractors who invoice $600 or more for services rendered during the tax year should receive Form 1099-NEC for reporting income. At the end of the year, use this form to report the total compensation paid to an independent contractor in the previous tax year. Send copies to the IRS and to the contractor by January 31st to report nonemployee compensation.

If filing by mail, you should also file Form 1096, which includes the combined totals for all independent contractors who received $600 or more in payments during the previous tax year.

IRS Compliance

While independent contractors do not receive all the same protections (overtime, mandated breaks, access to benefits, etc.) as employees, you are still responsible for following all relevant federal, state, and local laws. Under the IRS requirements, this primarily involves classifying workers correctly and filing the correct forms.

Avoiding Misclassification

Working with independent contractors can carry a significant risk of misclassification. To avoid misclassification, assess the worker relationship using all applicable tests, such as the IRS test and others.

Independent Contractors vs. Employees: Which Should You Choose?

As the independent workforce grows, businesses increasingly have access to skilled talent on a contract basis. But how do you know whether you should engage a contractor or hire an employee?

Start by considering the details of the job. For example, an employee may be the best fit if the job entails ongoing supervision, control of the time and resources used, and if the work is indispensable to your business. An independent contractor might be more desirable if the task is peripheral to your business, can be completed by an expert who doesn't need supervision, and/or entails a short-term engagement.

Take time to assess the pros and cons of each type of worker; each offers advantages, challenges, and other considerations. When you're ready to move forward, take care to classify your workers appropriately and consistent with applicable laws as employees or independent contractors.