Employee vs Contractor - Know the Difference!

In any business, ensuring you have the right people in the right roles can be the difference between success and failure.  To put together the right team you need to understand when to utilize an employee vs contractor.  You not only need to be clear on the roles and responsibilities, but you need to understand the cost implications, so you can make the best decision for the future success of your company.

Understanding the Difference Between an Employee and Contractor

As the employer you should consider if you have the right to direct and control the result of the work performed.  Generally, you will enter into a contract with an independent contractor agreeing services to be performed at a specified rate, which the contractor will pay taxes from the money they receive from the business.  Whereas, an employee will be part of the business, they will have a supervisor and the business will be determining their schedule and workflow, the business will be responsible for withholding and paying their taxes.  

Worker classification is important because it determines if the employer must withhold income taxes and pay social security, medicare taxes and unemployment tax on wages paid to an employee (W-2 Employee).  An employer does not have to withhold or pay taxes on payments to independent contractors (1099 Contractor).

There are many considerations when reviewing the relationship with a worker.  The IRS reviews the following three categories to determine the appropriate classification of a worker: behavior control, financial control and relationship of the parties.

Behavior Control:

Does the business have the right to direct and control the work performed by the worker, even if not exercised?  If so, the worker would be considered an employee.  Additional considerations to review are the type and degree of instructions provided to the worker and training provided to the worker.

Financial Control:

Does the business have the right to direct and control the financial aspects of the workers job?  If the business dictates hourly or salary pay rates and provides vacation and sick days, the worker would likely be considered an employee.

Relationship:

Does the business have a contract in place with the worker to limit the services provided to the public or preventing the worker from working with another company?  If so, the worker would likely be considered an employee.

There are many considerations to review when making the appropriate determination between an employee and contractor, refer to the 20-point checking to assist in determining a worker’s status. (https://twc.texas.gov/files/businesses/form-c-8-employment-status-comparative-approach-twc.pdf)

Consequences of Misclassifying an Employee

As the business owner, it is important to have a reasonable basis for the classification of workers as independent contractors as you may be able to avoid paying employment taxes.  If you classify a worker as an independent contractor with no reasonable basis you will be liable for employment taxes.   

If you have reviewed all roles and responsibilities of the business and the worker and you are still uncertain on the classification of employee or independent contractor, the business can File Form SS-8 Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding with the IRS to reach a determination.

https://www.irs.gov/pub/irs-pdf/fss8.pdf

Cost Differences for the Employer

Depending on what benefits are provided to employees and what State your business operates in the additional employer related taxes and costs to hire an employee averages about 50% of the gross salary, including:

-Employer Social Security 

-Employer Medicare

-Federal Unemployment Tax Act (FUTA)

-State Unemployment Tax Act (SUTA)

-Employment Training Tax (ETT)

-Vacation days

-Holiday days

-Sick days

-Personal days

-Health, dental and life insurance

-Workers Compensation Insurance

-Retirement plan benefits

-Bonus

I know what you are probably thinking, 50% on top of the gross salary - no way!  YES way, the additional costs to hire an employee add up quickly and if you want to attract top talent you need to be competitive in your employee benefit offering.  

Let’s review an Example

Small businesses often reach a certain level of growth and are at the point where they need the expertise of an experienced Finance Manager (more than 5 years of experience), but not sure they need them full-time just yet.   So they go out and find a highly recommended independent contractor, who has all the experience and qualifications they are seeking.  However, they start to reconsider when they learn the independent contractor is charging $95 per hour and their response is often I can hire a full-time Finance Manager for $60 per hour.  While, this sounds like savings of $35 per hour the comparison and analysis is flawed as the additional costs of hiring the employee need to be taken into consideration.   Let’s review the calculation below:

The median Finance Manager salary according to the Bureau of Labor Statistics (https://www.bls.gov/ooh/management/financial-managers.htm), is $125,080 for 2017.  

Gross Salary for Finance Manager                                          $125,080 (base per hour $60)

Additional Employer related costs                                           $62,540 (additional per hour $30)

Total Employer Costs                                                                  $187,620 (total per hour $90)

Additionally, we need to look at this holistically because we need to provide a place for the employee to work, we need to keep the lights on, telephone and internet working, we need to set the employee up with a computer, we need to pay the employees thus incurring payroll processing fees, we need to train the employee and manage their day to day workflow to maximize productivity…you get the idea the expenses don’t stop after the employee accepts your competitive offer.  There are administration costs involved to have employees, which for our example let’s assume those costs approximate ~15% of gross salary depending on city, state, type of office space, industry, etc. (each business will be different).

Administration Costs                                                                   $18,762 (admin costs per hour $9)

Total Employer Costs Including Admin Costs                     $206,382 (total per hour $99)

So you see, hiring the contractor for $95 per hour vs the employee for $99 per hour could be financially beneficial not to mention saving you many hours of time in recruiting, interviewing, training, managing etc.   Additionally, this is assuming the business has enough work to keep the employee 100% utilized or else you are actually losing more money hiring the employee vs contractor.  

The Bottom Line

Each business and situation is unique, and a detail analysis needs to be performed to review the benefits and costs of each scenario when deciding between an employee and contractor.  There are many benefits to outsourcing responsibilities within your business, see our article outsourcing accounting benefits for more information.