Hiring Contractors vs. Employees

When small business owners need assistance completing projects, they typically choose between bringing on an independent contractor or hiring an employee. For some businesses, working with a contractor on a per-project basis is optimal, but for others, a full-time employee meets their immediate needs. While the decision can sometimes be clear-cut, it can be a more difficult deliberation for many small businesses.

Small business owners deciding between hiring a traditional employee and a 1099 independent contractor should use this guide to understand the key differences, applicable tax treatment, the pros and cons of each, and how to avoid costly misclassification penalties.

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. For income tax purposes, the IRS considers self-employed individuals independent contractors.

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 as sole proprietorships or single-member LLCs. While they're taxed identically, operating as a sole proprietor means the freelancer and the business aren't legally separate. At the same time, an LLC is a distinct legal entity that generally shields the contractor's personal assets from business liabilities. For workers in high-risk industries, this protection is essential.

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 applicable 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.

Employee/contractor distinctions at a glance.

Behavioral Control

Businesses impose control over employees’ schedules and work methods but generally 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 to use

• 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 and bear responsibility for 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 like:

• 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 enter into a contract that describes the relationship. The following factors indicate the type of relationship, including:

• 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 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 to handle cashier responsibilities and an independent contractor to design the website.

Employment status factors depend on the specific operations of each business. Employment relationships vary, so we recommend consulting with payroll tax professionals to help you accurately classify your workers.

How the IRS and Department of Labor Classify Workers

The IRS common-law rules and Form SS-8

IRS common-law rules state that a worker is your employee if they meet certain standards, including behavioral control, financial control, and the nature of the relationship. If that determination is unclear, contact the IRS for guidance.

Either the business or the worker in question can file IRS Form SS-8, the document used to request a formal worker classification determination from the IRS. While this clarity is useful, response times typically take six months.

The DOL economic reality test and the 2026 proposed rule

The Fair Labor Standards Act, a federal law from the 1930s, features an economic reality test used to determine whether a worker is economically dependent on the business (typically an employee) or in business for themselves (typically a contractor).

The Department of Labor's 2024 final rule uses a six-factor, totality-of-the-circumstances test, which is the current standard. However, in 2026, the Department of Labor proposed (not finalized) rescinding the 2024 rule in favor of a 2021-style test that emphasizes two core factors:

• The worker's control over their work

• Their opportunity for profit or loss

If a final rule is published, we recommend revisiting contractor classifications at that time.

Hiring Independent Contractors vs. Hiring Employees

Your small business can reduce employment costs by hiring a freelancer instead of a full-time employee. 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.

Pros of Hiring Independent Contractors

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

• 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 and match them, but not with 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. These requirements don’t necessarily apply to freelance workers.

• Less oversight and team management responsibilities: Freelancers manage their time and take ownership of 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 periods and human resources costs by engaging freelancers for specific projects or short-term assignments.

Cons of Hiring Independent Contractors

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

• Penalties for misclassification: The IRS imposes fines on employers that misclassify workers. Businesses can incur penalties and back taxes for failing to follow IRS worker classification rules.

• Less control over workers: Contractors set their own schedules and work methods, leaving employers with less control over freelancers' 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, Request for Taxpayer Identification Number and Certification, from each independent contractor and submit 1099s to report nonemployee compensation to the IRS. Business owners must also comply with reporting deadlines to avoid notices and fines.

Pros and Cons of Hiring Employees

While some projects may be a better fit for freelance help, traditional W-2 employees can make invaluable contributions to your small business. Consider the pros and cons of hiring employees as you weigh which worker classification is best for your organization.

When you hire an employee, you have greater control over their schedule and work methods. This can help build strong long-term loyalty to your business, increase institutional knowledge, and make it much easier to scale a reliable core team. Employees can also be trained into specialized or evolving roles. These are considered some of the most compelling pros of W-2 employees, but it's not all upside.

Some of the biggest cons of hiring an employee are higher overhead from payroll taxes and benefits, greater administrative and compliance burdens (like onboarding, unemployment insurance, and workers' compensation), and less flexibility to scale down quickly during slow periods.

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, assuming payments meet the appropriate thresholds ($2,000+ in 2026). IRS Form 1099-NEC reports nonemployee compensation and other business payments, and should be sent to contractors and the IRS no later than January 31 of the following tax year.

It's a best practice to collect a completed IRS Form W-9 from each contractor before the first payment is made.

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. Like a contractor's 1099, send this form to employees by January 31.

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 employees' wages but not on independent contractors' 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. Section 530 relief can protect your business from IRS back taxes if you had a reasonable basis for treating a worker as a contractor.

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.

State-Level Worker Classification Rules

Federal worker classification rules are a floor, not a ceiling. States can apply stricter tests, so it's important to understand any additional rules your business may be subject to.

Take California's ABC test used to determine classification. To classify a worker as an independent contractor, your business would need to satisfy all three conditions in California:

• A (Control)

• B (Usual Business)

• C (Independent Business)

If you hire across state lines, it's a best practice to confirm the rules in each state where a worker performs services.

How to Decide: Contractor or Employee for Your Business

Sometimes the decision to hire an employee or contractor is an easy call, while at other times the decision is more complex. If you're still struggling with which direction to take, ask yourself:

• Is the work project-based and finite, or ongoing and central to your operations?

• Do you need to strictly control the worker's schedule, tools, and methods, or just the end result?

• Can the role be filled by someone who also serves other clients?

Dedicated accountants and tax advisors can review the specific facts of a prospective working relationship before moving forward with a hire.

FAQs about Hiring Contractors vs. Employees

Can an independent contractor work full time for one company?

Yes, an independent contractor can legally work full-time hours for a single client. However, working exclusively for one company can increase the risk that the IRS will view the worker as misclassified. The critical factor is whether the company controls how the work is done, rather than the number of hours billed.

What is Form SS-8, and when should a business file it?

Form SS-8 is an IRS document used to request an official determination of a worker's federal employment status. Businesses or workers can file this form when they cannot agree on whether a role should be classified as a W-2 employee or a 1099 independent contractor. The IRS reviews the facts regarding behavioral control, financial control, and the relationship dynamics to issue a formal ruling. Formal rulings can take as long as six months.

Do I need a written contract for a 1099 worker?

While a written contract is not legally required in every jurisdiction, it is highly recommended to protect both parties. A solid agreement clearly defines the scope of work, payment terms, and ownership of the intellectual property created. Most importantly, it serves as vital evidence of the relationship's independence if the tax authorities ever audit your business.

What happens if I unintentionally misclassify a worker?

Even if the mistake is unintentional, a business can face significant financial penalties for misclassifying workers. The company may be held liable for back taxes, unpaid federal unemployment insurance, and unpaid workers' compensation premiums. However, businesses that make an honest mistake may qualify for IRS relief programs, such as the Voluntary Classification Settlement Program, which reduces the total financial penalty.

Can a contractor later become a full-time employee?

Yes, transitioning an independent contractor into a regular W-2 employee is a common and legal business practice. This shift often occurs when a company requires greater control over workers' schedules or when the project becomes a permanent core function of the business. To do this properly, the business must terminate the contractor agreement and onboard the individual using standard employee documentation, such as IRS Form W-4, Employee's Withholding Certificate, and Form I-9, Employment Eligibility Verification.

Are independent contractors entitled to overtime pay?

No, traditional independent contractors are not covered by the Fair Labor Standards Act and do not have a legal right to overtime pay. Their compensation is strictly dictated by the terms of their contract, which usually involves a flat project fee or a standard hourly rate. If a contractor demands overtime pay, it is often a sign that their job duties have evolved into those of an employee, which requires a reevaluation of their classification status.

Building a Hiring Strategy That Fits Your Business

There are several benefits and challenges to hiring contractors and employees. The right fit for your business may be totally wrong for another business owner, but whichever you choose, it's important to understand your obligations from day one. While you can do it yourself, federal and state compliance is easy with expert support.

Don’t let hiring decisions hold up your small business operations. Consult with 1-800Accountant's tax advisory professionals for year-round help with worker classification, employment tax compliance, and strategic business planning.