A question we often get from clients is whether they should hire employees or independent contractors.

Most of the time, business owners focus on the financial aspects of the decision. Will hiring an independent contractor help them save on Social Security and Medicare taxes, vacation pay, and other employee benefits? While that might be one factor in your decision, a more important question is which suits your business needs.

Let’s walk through the differences between an employee and an independent contractor and why it matters.

IRS employee vs contractor basics

First things first, let’s define our terms. An employee works in your business and is on the payroll. They often have set hours and you, as the business owner, control what they do and how they do it.

On the other hand, an independent contractor is more like a guest chef in your kitchen – they come in, do a specific job, and leave without being part of the regular staff. As the business owner, you have the right to control the direct result of their work, but not where, when or how they do it.

The Internal Revenue Service (IRS) looks at three factors when deciding whether a worker is an independent contractor or an employee.

1. Behavioral. Does the company have the right to control what the worker does and how they do their job? Employees typically work specific hours at a particular location. Independent contractors have more control over when and how they work.
2. Financial. Does the business control the financial aspects of the worker’s job? This might include when and how the worker gets paid, whether the company reimburses expenses, and who provides tools and supplies. An independent contractor might do the same or similar work for multiple businesses, whereas a company can legally limit the rights of their employees to work a second job—especially if working for another company would interfere or compete with the duties of their primary job.
3. Relationship of the parties. Is there a written contract between the business and the worker? Does the company provide employee benefits, such as retirement accounts, health insurance, and vacation pay? Is the work performed a key aspect of the business? Typically, employees perform work that is essential to the business. For example, if you own a restaurant, your cooks are part-time or full-time employees. However, you might outsource marketing and bookkeeping to an independent contractor.

It’s important to note that simply having an independent contractor agreement in place isn’t enough to establish that the worker is an employee. The IRS will look at all the facts and circumstances.

The pros and cons

Now, let’s look at some pros and cons of hiring an independent contractor vs an employee.

Independent Contractors

Pros

• Cost-effective: Generally, you pay for the work done without the extra expense of benefits and employment taxes
• Specialized skills: Independent contractors often bring specific expertise that you might need temporarily
• Flexibility: You can bring on an independent contractor on an as-needed basis and scale back or eliminate their services when you need to cut expenses or conserve cash

Cons

• Less control: You can direct the result but not the nitty-gritty of how it’s done
• Less loyalty: Their commitment might be split among various clients—your business needs might not always be their top priority
• Legal risks: Misclassifying an employee as a contractor can lead to legal headaches and owing back payroll taxes and penalties

Employees

Pros

• Loyalty and commitment: Employees are generally more invested in your company’s long-term vision and strategic plan
• Control: You have more say over how, when, and where the work is done
• Team cohesion: Employees can foster a stronger team dynamic and company culture

Cons

• Cost: They come with additional costs like benefits, taxes, and insurance
• Compliance: There’s a maze of employment laws and regulations to navigate
• Less flexibility: Scaling up or down can be more challenging with permanent staff

Why does it matter?

The IRS and the U.S. Department of Labor (DOL) don’t fool around when it comes to classifying workers as employees versus independent contractors.

If they determine you’ve misclassified workers (intentionally or not), you could face fines from the DOL, IRS, and state agencies. Other potential consequences include:

• Criminal penalties and liability for back wages, unpaid overtime, and minimum wage deficits
• Penalties for failing to withhold and remit federal income taxes, Social Security and Medicare taxes, and state income tax and payroll taxes
• Liability for not keeping properly completed Form I-9s on file for each employee
• Unemployment insurance shortfalls
• Unpaid workers’ compensation premiums
• Lawsuits for failing to provide benefits, such as pension plan or retirement plan coverage, employer-sponsored health insurance, paid leave allowances, severance pay, etc.

Bottom line: you can’t afford to misclassify workers. It might save you money in the short term, but the potential long-term consequences aren’t worth the risk.

If you’ve reached this point and realized you have some misclassified workers, there is still time to get it right. The IRS’s Voluntary Classification Settlement Program allows businesses to reclassify workers for future tax periods with partial relief from federal employment taxes. You can apply for the program by filling out Form 8952.

Evolving state regulations

Above, we focused on the federal rules for classifying workers. However, some states, like California, play by their own rules with stricter guidelines. For example, California uses an “ABC” Test to determine whether a worker is an employee or a contractor.

Under the ABC Test rules, employers must start with the presumption that a worker is an employee. To classify them as a contractor, they need to demonstrate (and document) that the worker meets all three criteria of the ABC Test:

a) the worker is free from company control and direction in the performance of services

b) the worker performs work outside of the usual course of business in the company

c) the worker is customarily engaged in an independently established trade, business, or profession

Several other states also use the ABC Test or use two out of three of the ABC tests. Keeping up with evolving state regulations can be complicated, so this is where a tax advisor comes in handy.

Make worker classification questions a thing of the past

Don’t assume you can classify workers in the most cost-effective way now and worry about the consequences if you get caught. Work with a professional who can help you navigate your situation and ensure you comply with state and federal regulations.

Choosing between an employee and an independent contractor isn’t about finding a universally ‘better’ option. It’s about what fits your business needs and complies with federal and state regulations. What works for one business might not work for another. So, reach out for guidance. After all, making informed decisions is part of the adventure of running a business, isn’t it?