Employee vs. Contractor: Which Should You Hire?

It’s more than just the form used to report taxes

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Understanding the differences between an employee and an independent contractor involves more than choosing the right tax form. 

Hiring employees can be more expensive than hiring contractors due to the cost of training, benefit packages, and expectation of raises and bonuses. But employees are better equipped to take on additional responsibilities and have more flexibility to help your business succeed. Contractors are typically paid by the hour or project and do not require these other costs. However, they do require more independence. 

Depending on your business needs and other factors like taxes, benefits, and worker supervision, one option may make more sense than the other. Learn how to evaluate these variables and determine whether you should hire an employee or a contractor. 

What’s the Difference Between Contractors and Employees?

Employees are typically full-time, permanent, and awarded benefits offered by the company, while contractors are often part-time, temporary, or project-based and receive limited to no benefits.

Both are given tasks to complete for the business, but employees are typically assigned more diverse tasks and managerial responsibilities, while contractors tend to focus on duties that can be handled independently.

  Employees  Contractors
 Hiring Process  Employees are vetted, offered positions, and hired by human resources. Once hired, the employer must request additional information from the employee, such as date of birth, marital status, and citizenship status. A contractor communicates with a person or business that wants a specific service or task completed. After their job proposal is accepted, a contractor signs a contract with a business for the length of the project and based on agreed-upon terms. 
Tax Forms  A W-4 form captures the employee’s name, address, Social Security number, tax filing status, and number of exemptions. A W-9 form is used to record their name, address, Taxpayer Identification Number (TIN), and certification about backup withholding.  Form 1099 reports payments over $600 or more in a calendar year. 
 Tax Reporting  The employer reports all money paid to the employee during the tax year on a W-2 form, including state and federal taxes. Employers and employees each contribute 6.2% to Social Security taxes and 1.45% to Medicare taxes, in a 50-50 split. Only employers pay FUTA taxes. Contractors report their state and federal taxes and pay both the employee and employer portion of FICA self-employment taxes, 15.3% of their income. 
 Insurance Unemployment insurance is offered by the DOL to employees who meet specific eligibility requirements. Unemployment insurance is not available to independent contractors. 
Pay Terms Employees earn either an hourly rate or a salary for an unspecified amount of time. Employers can also offer commissions and bonuses. Independent contractors are typically paid hourly or by the project, for a defined period of time, such as six months or until the project is completed. 
Pay Delivery Employees are paid by their company on a regular weekly, bi-weekly, semi-monthly, or other basis that was agreed upon at the time of hire. States have different laws regarding how frequently employees are paid. Contractors invoice a business for payment based on arrangements agreed upon prior to the work being performed. 

Tax Responsibility

One difference between contractor and employee income is how their taxes are structured. Employers withhold income for taxes from employees’ paychecks but not from independent contractors' paychecks. Contractors are technically self-employed and their earnings are subject to self-employment taxes (Social Security and Medicare, also known as FICA.)

Employers report employee income using a W-2; independent contractor income is reported using a 1099.

Work Supervision

Business owners have more control over where, when, and how their employees perform tasks. Contractors receive less direction regarding how tasks are completed. If you desire more worker supervision and project oversight, hire employees. Contractors can fill your business needs for more flexible, low-supervision projects.

Benefits

Employees are often offered benefits by their employers, such as health insurance, retirement plans, paid vacation time, and sick days; contractors are not. Employees are also incentivized to perform well with raises, commissions, or bonuses. Contractors can be offered incentives as well, but it’s not expected.

Relationship

A contractor is often hired for a specific project, and businesses can decide to continue or terminate the relationship after the project has been completed. Employees are hired on a more permanent basis and typically have longer, more stable relationships. Independent contractors work for themselves while providing you a service or product, while employees work for you on your terms.

Payment Expectations

Employees are compensated on an hourly or salaried basis and are paid on a fixed recurring pay period. Contractors are paid by the hour or project according to prearranged terms. Accounts payable pays a contractor after receiving an invoice. The contract terms should dictate when payments are made, such as upon completion of a task or in periodic amounts. 

Employee or Contractor: Which Is Right For You?

To decide who to hire, ask yourself some questions. Do you need control over how and when a job is performed? Can you provide tools and supplies for the task? Would you rather relinquish direction and save money or maintain control and spend more? Are you seeking to fill a temporary need or looking to fill a critical role in your business?

Consider carefully before hiring. There are consequences to misclassifying workers. Treating a contractor as an employee without offering benefits or withholding taxes can get you in trouble with the government.

When Contractors Are Right for Your Business

Solid business-contractor partnerships are built on clearly defined expectations, good documentation, and mutually beneficial goals. Stability for the contractor and risk management for the business allows both parties to work in harmony. As long as you deliver your end of the deal, partnering with a contractor can mean less red tape and cost-effective task completion.

When Employees Are Right for Your Business

Contractors are loyal to their own business goals first and may leave for a better offer if it comes along. If you value reliability, need more worker control, or hope to hand-off administrative and managerial duties that will require training, hiring an employee may be the better option.

A Best-of-Both Worlds Option

Some businesses choose to use full-time employees and contractors. How can you hire and manage both employees and contractors within a business? Delegate tasks and divide up work according to skill sets so that each group has something they can handle well.

If you want to hire short-term help, decide on the best contractor for each project based on skill and expertise. If you want to hire employees, find individuals to fill a specific role, and decide what the position pays and how a person will perform their job.

Provide regular, constructive feedback for both contractors and employees to grow and improve their skills in their respective tasks.

The Bottom Line

Make sure you know exactly what you require from a worker and how much you can invest in them before hiring anyone. If you need a full-time worker to help run the business and are willing to spend the time and resources, hire an employee. Partner with a contractor if you can offer a competitive hourly rate and need flexibility but can't offer benefits. Either way, clearly define expectations beforehand and treat both kinds of workers with the respect they deserve.

Frequently Asked Questions (FAQs)

What is the difference in taxes between an employee and independent contractor?

Independent contractors pay significantly more in taxes than employees. Employers and employees share taxes paid on their wages or salaries, while independent contractors are responsible for all self-employment tax on the net profit they make each year. For contractors, this results in paying 15.3% of (12.4% for Social Security and 2.9% for Medicare) paid in quarterly estimated tax payments and year-end personal income taxes. Employees only pay half of that 15.3%.

Who decides if a worker is an independent contractor vs. an employee?

The IRS guidelines look at behavioral control, financial control, and relationship to determine the worker's employment status. If you provide the tools and training and have expectations for when, how, and where someone works—that's an employee. Anything else is a contracted worker arrangement. 

What is the average cost per worker to have an employee vs. an independent contractor?

In December 2021, employee compensation was costing businesses an average of $40.35 per hour. You can hire independent contractors for less cost long-term; however, they charge higher hourly rates to compensate for their self-employment taxes. A general rule of thumb is that hourly contractor rates are 50% to 70% more than what you would pay a permanent employee.


Article Sources

  1. U.S. Department of Health and Human Services: Office of Child Support Enforcement. “What’s the Difference Between an Independent Contractor and an Employee?

  2. Internal Revenue Service. “About Form 1099-MISC Miscellaneous Income.”

  3. Internal Revenue Service. “Topic No. 751 Social Security and Medicare Withholding Rates.”

  4. U.S. Department of Labor. "Misclassification of Employees as Independent Contractors."

  5.  Internal Revenue Service. “Topic No. 751 Social Security and Medicare Withholding Rates.”

  6.  Bureau of Labor Statistics. “Employer Costs for Employee Compensation.”