Hiring Contractors vs Employees: Benefits and Challenges

If you’re a small business owner, you manage many aspects of your business, from budgeting to sales and customer service. When you want help with special projects, you need to prioritize: Do you save money by doing the project yourself, or save time by hiring help?

Fortunately, small businesses can save money by hiring independent contractors instead of full-time employees. 

Small business owners can enjoy both cost and time savings by hiring freelancers. Contractors offer a short-term solution to support your business while reducing employment taxes and overhead costs. 

This article will explain the benefits and disadvantages of hiring contractors vs. employees and the classification rules your business must follow. 

What Is an Independent Contractor?

An independent contractor, also known as a freelancer, is a self-employed individual who sells products or services to the public. 

Independent contractors set their own schedules and use their own resources to perform the work. Unlike employees, freelancers control when and how they complete their work.

Freelancers and independent contractors can operate sole proprietorships or single-member LLCs. For income tax purposes, the Internal Revenue Service (IRS) considers self-employed individuals independent contractors.

Key Differences Between Contractors and Employees

Independent contractors create unique reporting rules for your business. Understanding the differences between freelancers and employees is critical to complying with employment laws.

The IRS generally distinguishes an independent contractor from an employee by the degree of control the worker maintains over their work. For example, consider which party determines the worker’s schedule and work location. Independent contractors establish their own hours and location, while employees must follow company policies.

The IRS examines several factors to determine the nature of an employment relationship. Consider the following rules and consult with professional tax advisors to avoid misclassification of your workers.

Behavioral Control

Businesses impose control over employees’ schedules and work methods but cannot control when or how freelancers work. 

Employers provide new employees with detailed instructions, role expectations, and job-specific training. Company policies may specify the following rules for employees:

• Work hours and location
  
• Preferred methods for completing assigned responsibilities
  
• Required supplies, tools, and equipment
  
• Frequency and nature of performance reviews

In contrast, independent contractors establish their work hours, locations, and methods. Freelancers invest in their own equipment and specialized training. Additionally, independent contractors bear the responsibility of requesting feedback from clients.

Financial Control

Employer-employee relationships generally give the employer financial control. Unlike employees, independent contractors maintain financial responsibility. To determine the type of worker, the IRS considers factors such as the following:

• Reimbursement of expenses: Employers reimburse most employee expenses, while independent contractors pay for their own tools, overhead, and operational costs.
  
• Payment method and timing: Employees receive paychecks on an employer-designated schedule. In contrast, freelancers designate a project fee, pay rate, and payment due date.

• Offering services to the market: Independent contractors must market their services and generate ongoing business. Contractors actively seek new client work, while employees rely on continued employment with the same company.

Type of Relationship

Whether the business hires an employee or a freelancer, the parties should establish a contract describing the relationship. The following factors indicate the type of relationship:

• Permanency: An ongoing or long-term employment contract suggests an employer-employee relationship. Freelance contracts often end after the completion of a specific project.
  
• Employment benefits: Full-time employees enjoy employment benefits such as health insurance and employer-sponsored retirement plans. In contrast, independent contractors cannot participate in benefit plans.
  
• Nature of services provided: Companies hire freelancers for specialized skill sets or short-term services rather than supporting their main business activities. For example, a restaurant would likely hire a part-time employee for cashier responsibilities and an independent contractor for website design.

The employment status factors depend on the unique operations of each business. Employment relationships vary, so we recommend consulting with payroll tax professionals for help accurately classifying your workers. 

Hiring Independent Contractors vs. Hiring Employees

Your small business can reduce employment costs by hiring a freelancer instead of a full-time employee. For example, independent contractors do not require employment tax reporting or healthcare benefits from the business.

Consider the pros and cons of hiring freelancers vs. employees. Depending on the nature of the work and your company culture, you can determine whether hiring an independent contractor is a viable solution for your business. 

1-800Accountant offers small business tax advisory services to help you find the most cost-effective employment solutions. 

Pros of Hiring Independent Contractors

Your business can benefit from fewer tax responsibilities and less oversight by hiring independent contractors. Contractors offer a short-term solution for help with a specific project. The advantages of hiring freelancers include the following: 

• Simplified employment tax compliance: Businesses enjoy fewer employment costs when hiring contractors instead of employees. Employers must withhold Social Security and Medicare taxes on employee wages but not contractor fees. Additionally, federal unemployment tax and state unemployment insurance only apply to employees.
  
• Lower employee benefit costs: Freelancers are ineligible for employee benefits offered to full-time employees. Businesses that hire independent contractors can save money on health insurance, retirement plans, office space, and workers’ compensation. 

• Flexibility in contractor fees: The Department of Labor imposes labor laws and minimum wage rules to ensure fair pay to employees. However, the requirements don’t necessarily apply to freelance workers.
  
• Less oversight and team management responsibilities: Freelancers employ time management and ownership over deadlines, so clients don’t need to monitor their progress. Business owners can stay focused on operations instead of project management.

• Smooth onboarding process: Independent contractors often provide specialized services and technical expertise. Businesses can avoid lengthy training times and human resources costs because freelancers focus on specific projects or short-term assignments.

Cons of Hiring Independent Contractors

Business owners can save time and employment costs by hiring contractors. However, business owners must follow IRS worker classification rules to avoid penalties. Disadvantages of hiring independent contractors include the following: 

• Penalties for misclassification: The IRS imposes fines for misclassifying workers. Businesses can incur penalties and back taxes for failing to follow IRS worker classification rules.
  
• Less control over workers: Contractors establish their own schedules and work methods, giving employers less control over freelancer hours and project completion. Businesses can enforce company policies over employees but cannot impose strict requirements on freelancers.
  
• Unique reporting requirements: Businesses must collect an IRS Form W-9 from each independent contractor and submit 1099s to report non-employee compensation to the IRS. Business owners must comply with reporting deadlines to avoid notices and fines. 

1-800Accountant can support your business with employment tax and informational reporting. We recommend consulting professional CPAs for budget-friendly payroll tax assistance.

Taxes for Contractors vs. Employees

Taxes for Independent Contractors

Small business owners enjoy simpler tax responsibilities for independent contractors than for employees. 

Freelancers must pay self-employment taxes on their wages. Employers have no responsibility to withhold income taxes on contractor payments. Companies must instead file informational returns to report payments to freelancers. IRS Form 1099 reports non-employee compensation and various other business payments. 

Taxes for Employees

Employers must comply with payroll tax reporting requirements for full- and part-time employees. Some rules vary by location. 

Businesses with one or more employees must withhold Social Security and Medicare taxes (FICA) on employee wages. Employers must also comply with federal unemployment tax and state unemployment insurance reporting requirements. 

Businesses issue a W-2 form to every employee to report compensation and tax withholding each calendar year.

Penalties for Misclassifying Workers

Companies can face back taxes and fines for purposely or mistakenly misclassifying workers. 

Employers must withhold and remit payroll taxes on employee wages but not independent contractor payments. If a company fails to withhold employment taxes on a worker’s wages, the business must generally pay the withholding taxes on the misclassified worker’s compensation. 

For example, consider a business that hires a contractor on a full-time, ongoing basis and closely monitors the worker’s performance. The IRS could examine the employment relationship to determine the correct worker status. If the IRS finds the contractor should have been classified as an employee, the company could owe payroll taxes and penalties on the worker’s wages.

Tax avoidance can lead to fines, but the IRS allows certain exceptions for mistakes. If your business finds a classification error, you could qualify for an exception from paying employment taxes on the misclassified worker’s wages.

We recommend establishing clear expectations for all employee and contractor relationships. Create a written contract including payment terms, contract length, and each party’s responsibilities for determining work hours and methods. 

Small business tax advisors can help you classify workers and comply with complex payroll tax rules.

Make Hiring Seamless with 1-800Accountant

Don’t let hiring decisions hold up your small business operations. 1-800Accountant can support your business with low-cost payroll tax services. Professional CPAs help you understand your reporting obligations, prepare accurate returns, and meet deadlines.
Consult with tax advisory professionals for help with worker classification, employment tax compliance, and strategic business planning. Schedule a free call with 1-800Accountant to learn how your business can benefit from hiring independent contractors.