As a business owner, you’ll eventually need to bring on a new hire and start growing your team. However, there are differences in types of hires, and misclassifying them can result in hefty fines, back taxes, and more. Here, we’ll talk about the difference between employees and independent contractors, how they affect business payroll, and which option is better for small business owners.
Understanding Worker Classifications: Employees vs. Independent Contractors
Worker classification refers to the process of determining whether a person performing services for a business should be legally considered an employee or an independent contractor. This classification can affect everything from taxes and benefits to legal and financial responsibilities that the employer has to the employee. The fundamental difference between the two is the nature of the working relationship.
Understanding Common Law Rules
The IRS uses common law rules to determine the level of control and independence in a working relationship. These rules help decide whether a worker should be classified as an employee or an independent contractor for tax purposes. The three categories to help determine this are behavioral, financial, and the type of relationship.
Behavioral: Refers to whether the business has the right to direct how and when the worker performs their job.
Financial: Focuses on how the worker is paid and who controls the financial aspects of the job.
Type of Relationship: Examines how the worker and employer view their relationship.
According to the Internal Revenue Service, there’s no set number of factors that make an employee or an independent contractor, and no one factor stands alone in this determination. There may also be additional factors that need to be considered. If, after reviewing the categories and trying to classify a worker, it’s still unclear as to what they are, you can fill out Form SS-8 and file it with the IRS.
What is an Employee?
A W-2 employee is a person who works for a business or organization under an agreement or contract, where the employer controls not only what work is done, but also how it’s performed. Employees typically receive a regular paycheck or salary, and their employer is responsible for withholding payroll taxes, such as Social Security tax, Medicare, FUTA, and state taxes from their earnings.
In most cases, employees are also entitled to workplace benefits and protections, such as health insurance, paid time off, retirement contributions, and coverage under labor laws like minimum wage and overtime regulations. Because the employer assumes these financial and legal responsibilities, hiring employees generally involves higher administrative costs but provides greater control and long-term stability for the business.
What is an Independent Contractor?
A 1099 independent contractor is a self-employed individual or business entity that provides services to another organization but retains control over how, when, and where the work is performed. Unlike employees, independent contractors are not subject to direct supervision or detailed instructions from the hiring business.
Contractors are typically paid per project, per task, or per deliverable, rather than receiving a regular wage or salary. They’re responsible for handling their own Social Security and Medicare taxes (self-employment tax), and any income tax withholding requirements. Contractors are also not eligible for employee benefits such as health insurance, paid leave, or retirement plans.
While hiring independent contractors can offer cost savings and flexibility for employers, it also comes with less control and a higher risk of misclassification if the working relationship resembles that of an employee. Businesses must apply IRS and labor guidelines carefully to ensure proper classification and compliance.
Key Differences Between Employees and Independent Contractors
The primary difference between employees and contractors is the degree of control, along with the tax responsibilities and legal protections, as shown in the table below.
| Category | Employee | Independent Contractor |
|---|---|---|
| Level of Control | The employer has the right to control how, when, and where the work is done. | The contractor controls how and when the work is completed. |
| Financial Control | Paid a regular wage or salary through payroll. Employer covers business expenses. | Paid per project or deliverable; responsible for own expenses and tools. |
| Tax Responsibilities | Employer withholds income, Social Security, and Medicare taxes. | Contractor pays self-employment tax and handles all tax filings independently. |
| Benefits | May receive benefits such as health insurance, paid time off, and retirement plans. | Not eligible for employee benefits. |
| Legal Protections | Covered by labor laws, including minimum wage, overtime, and anti-discrimination protections. | Not covered by most labor laws or employee protections. |
| Permanency of Relationship | Typically ongoing or long-term with a set schedule. | Usually short-term or project-based with flexible scheduling. |
| Tools and Equipment | Provided and maintained by the employer. | Provided and maintained by the contractor. |
| Risk of Loss or Profit | Employee bears little financial risk; income is stable. | Contractor assumes risk and may profit or lose based on efficiency or costs. |
| Tax Forms | Must pay payroll taxes, unemployment insurance, and sometimes workers’ compensation. | No payroll tax obligations; payment is reported for IRS compliance. |
Pros and Cons of Hiring Employees vs. Contractors
Choosing between hiring an employee or an independent contractor depends on your business needs, budget, and the level of control you want over the work performed. Each option comes with distinct advantages and disadvantages, which are good to familiarize yourself with. In general, the pros and cons of each are as follows:
Hiring Employees
Pros:
✓ Greater control over how, when, and where work is done.
✓ Builds long-term loyalty and consistency within your team.
✓ Easier to train, manage, and integrate into company culture.
Cons:
✗ Higher costs due to payroll taxes, benefits, and insurance.
✗ More administrative work and compliance requirements.
✗ Less flexibility to scale workforce quickly during busy or slow periods.
Hiring Independent Contractors
Pros:
✓ Lower overall costs (no payroll taxes, benefits, or overtime pay).
✓ Flexible staffing for short-term or specialized projects.
✓ Reduced HR and administrative responsibilities.
Cons:
✗ Less control over how and when work is performed.
✗ Risk of misclassification if the contractor functions like an employee.
✗ Potential lack of long-term commitment or availability.
Hidden Costs of Misclassification and Strategic Tax Planning Tips
Since there are unique employer tax obligations for a W-2 employee vs. a 1099 independent contractor, misclassifying workers can lead to costly mistakes. Suppose you classify a worker as an independent contractor, and the IRS determines that they function more as an employee. In that case, you may be held responsible for back payroll taxes, Social Security and Medicare contributions, and unpaid unemployment tax or insurance. These back payments also often come with interest and significant penalties.
Misclassifications can also trigger IRS audits and even investigations by the Department of Labor, which may prompt the need for IRS representation. If the worker seeks lost wages and benefits, they may also file a lawsuit, which can further complicate the matter. Therefore, if you have any doubts or questions about the status of someone in your workforce, it’s best to work with a professional.
The professionals at Del Real Tax are experts in business accounting and bookkeeping and understand the nuances that determine worker classification and their associated tax implications. Schedule a free demo with us today to learn how we can help you with strategic tax planning regardless of employee relationships.
