Insureon Blog

Employee vs. contractor: How to make the right choice

11. May 2016 08:15

Business woman looking thoughtful

[Updated June 27, 2019]

By Harry J. Lew, Insureon Contributor

It’s often obvious when a small business needs to expand its staff: It’s missing deadlines, paying more overtime, and getting poor online reviews. What’s not obvious is whether a new worker should be an employee or independent contractor. Yet knowing how each type of worker is different and when to pick one over the other can save money and prevent future problems.

What’s the difference between employees and contractors?

An employee typically works on-site at your business or with a designated schedule at another location, works set hours, and is compensated through your payroll system, which deducts contributions for Social Security, Medicare, unemployment, and employee benefits.

Independent contractors, on the other hand, are self-employed individuals who make their own hours and submit invoices for completed work. They are also responsible for doing their own withholding of income and payroll taxes, and usually do not receive company benefits. In many cases, they work off-site or hours that differ from your employees.

It’s important to understand how the IRS and state tax authorities define employee vs. independent contractor status. Otherwise, your company could be at risk of paying unexpected taxes and penalties. It could also face legal liabilities if a regulatory agency rules that a contractor at your business actually qualifies as an employee.

Generally speaking, government authorities look for three things in evaluating whether independent contractor status is warranted:

Let’s take a closer look at each of these.

Control test

The IRS views the degree of control you have over a contractor as a key driver of tax status. Control consists of either behavioral measures or financial requirements. For example:

Relationship test

The IRS also looks at how the employer and independent contractor work together.

For example, having a written contract that explicitly defines a client / contractor relationship is helpful as long as it’s not just on paper. The IRS also looks for whether you are giving the person employee benefits, such as vacation or sick pay or pension or health insurance benefits. If you’re providing benefits, chances are the IRS will view your contractor as an employee.

Finally, a contractor who is considered an open-ended worker is more likely to be classified as an employee versus someone who is hired with a set start and end date.

Economic realities test

This test tries to determine the economics of the relationship. For example, it evaluates criteria such as:

How to avoid employee misclassification

While the above criteria are helpful, there’s no cut-and-dry legal distinction between contractors and employees. Employment judges evaluate the facts in each case to make rulings. Still, knowledge is power when dealing with such matters. Consider taking these steps to make sure you are classifying new hires correctly:

Finally, don’t let your need to reduce labor costs get you into trouble. As the owner of a small business, it’s crucial that you treat employees as employees. This involves:

Failing to comply with these items may have serious financial and legal consequences. Adhering to the law will always be your best strategy.

Which to choose: employee or contractor?

Employees are often more expensive because business owners owe payroll taxes on their wages. You also have to pay for workers’ compensation insurance and their employee benefits. However, saving money isn’t the only consideration. Hiring employees can also create more stability at your business and help you increase the core capabilities of your firm.

At the end of the day, deciding between an independent contractor and an employee hinges on your business requirements:

What are the tax implications of hiring an employee vs. contractor?

The tax implications are significant for employees. You have to withhold, report, and remit an employee’s income tax withholding, Social Security and Medicare taxes, as well as pay unemployment taxes to your state labor regulator. None of this is required for independent contractors.

You also need to file different tax forms based on the type of role you are hiring. If you pay an independent contractor $600 or more in a tax year, you need to file a form W-9, as well as Form 1099-MISC. For employees, you must file a Form W-2 and withhold and pay taxes and benefits.

If you fail to classify an independent contractor properly, the IRS and state tax and labor authorities may attempt to collect what you failed to pay, plus penalties. It’s best to avoid this situation.

What are the insurance implications of hiring an employee vs. contractor?

Each worker type brings different insurance concerns:

With independent contractors, you aren’t responsible financially if they get sick or injured on the job. However, you can be held liable for injuries or damages they cause to third parties while working for you. For this reason, it’s important to ask contractors to submit a certificate of liability insurance to confirm they have insurance coverage. Look for adequate general liability, E&O, or professional liability insurance limits. If there’s no existing coverage, consider finding another contractor.

What’s the bottom line?

As you consider hiring an employee vs. contractor to expand your business, remember these three takeaways:

Protect your company and employees with Insureon

Insureon provides an easy online application for businesses with employees and contractors to compare insurance quotes from top-rated carriers in the United States. Start an application to compare quotes and reduce your risks today.


Contractors | HR | Professional Liability Insurance | Small Business | Small Business Risk Management | Tips for All Small Businesses | Workers' Compensation Insurance

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