Employees Vs. Independent Contractors: A Guide for Business Owners

Author: David Averyt | Categories: Processes, Small Business
employees versus independent contractors

employees versus independent contractors

Debating between hiring employees versus independent contractors?

You’re in the right place. The media is making noise over the new gig economy where temporary and freelance workers fill companies’ labor needs rather than traditional employees. This ado is not for nothing. As this recent study reveals, over half of IT hiring managers currently utilize freelancers, and even more expect to in the future. Matching labor (IT or otherwise) with demand can be a shrewd business decision that keeps overhead low. Regrettably, however, employment and labor laws are not keeping pace with new realities of modern business.

So, before you staff up with gig workers, know the rules of the road.

Benefits of Independent Contractors

Let’s go straight to the bottom line. Independent contractors do not carry the ancillary costs that employees do. Independent contractors pay their own payroll taxes, overtime, health benefits, retirement plans, unemployment insurance, and workers compensation insurance. They may also pay for their own office space, computer, printer, supplies, automobile, phone, and training, though these are things you may provide for your own convenience. Those costs, both in money and time (someone must procure the equipment and supplies, comply with filing requirements, and generally administer the back office, right?) can be substantial. With an independent contractor, however, you can be all-in with what is reported on their 1099.

In addition, you can be quicker to hire. Did you like the resume and jibe over a cup of coffee? Great, get to work! The only paperwork involved is an engagement agreement (you do have one, right?). Short-term, project-related work can provide a good testing ground for both sides to validate initial impressions and determine whether there is truly a fit before committing to longer-term work. In this way, hiring mistakes can be mitigated and the costs of termination greatly reduced.

Employers Beware: The Dark Side of Employee Misclassification

So why not hire everyone on an independent contractor basis? ‘Cause the federal government says so, that’s why. Employees may carry higher costs all around, but they are the preferred classification of the IRS and the Department of Labor. In fact, the DOL has a Misclassification Initiative, that is, it is actively seeking to discover employers in violation of the Fair Labor Standards Act. If there’s a question regarding worker classification, the IRS and DOL will assert employee status.

The penalties for worker misclassification are onerous. Penalties can include:

  • 1.5% of misclassified wages, 40% of the employee’s FICA taxes
  • 100% of the employer’s FICA taxes
  • Failure-to-pay-taxes penalty up to 25% of the total tax
  • $50 for each W-2 that the employer failed to file because of misclassification.

Of course, for intentional or fraudulent misconduct, the consequences are even more severe—not only greater fines, but also possible criminal penalties up to $1000 per misclassified worker, 1 year imprisonment, and personal liability for uncollected taxes. Ouch. And here’s salt for the wound: even if you lawyer up and avoid the harshest penalties of the IRS and DOL, you’re still stuck with pricey legal fees.

Striking the Balance

So how does this apply to your company’s workers? First, don’t think you can simply contract around the rules. Despite a piece of paper that says, “I’m an independent contractor for XYZ Company!” if it walks and quacks like a duck, the authorities will call it a duck. (On the other hand, don’t take this to mean that you shouldn’t have written agreements. You should, for both employees and independent contractors.)

As a business owner, consider these guidelines when debating between independent contractors versus employees:

  • Outsource non-core functions. Build your business around its core. Hire employees who are essential to delivering your service or building your widget. If it’s not core, it’s a candidate for outsourcing. Think marketing, HR, IT, and accounting. Other people are professionals in those areas, so you don’t have to be.
  • Mind the culture. Your company culture will be defined by your employees. Contractors may influence it, and the mix of employees to contractors will certainly shape it, but culture—good or bad—springs from employees. So, when you hire, do so wisely.
  • Watch the clock. Quick, one-off projects lend themselves to contracting. Longer, more involved initiatives, especially those that will evolve as they develop over time, are better handled by employees. If a project will require substantial in-house training before a worker can dig in, you’re in the realm of employees.
  • Crunch the numbers. Whether an employee or an independent contractor, every worker must somehow contribute to the bottom line. But it’s not only about the bottom line. Do you have the cash to pay for the help you’re considering? (Need help analyzing your numbers? Give us a call or drop us a line right here.)

Of course, 20-factor tests and other technical classification mumbo-jumbo are still the rules that the IRS and Department of Labor enforce. Instead of boring you to tears reciting them, get what you need to know in the handy infographic below from our friends over at Gusto. And if you are still unclear, consult your professional tax or legal advisor.

Employee vs. Contractor: Is My Worker an Employee or Contractor? – An infographic by the team at Gusto.

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