Finance Forward Blog

When you run a small business, you need to maximize your resources and ensure that every dollar invested works as hard as you do. One of the ways to do that is to hire contractors instead of employees.

Working with contractors can save a lot of money and overhead. You don’t provide office space, you don’t have to offer full benefits, and you can focus on paying for projects rather than an hourly wage.

However, it’s essential to make sure you give contractors the freedoms they deserve as well. If you treat them as employees but classify them as contractors, you could end up in a lot of trouble.

Employees vs. Contractors

When you have employees, there’s a lot of organizational work that must be done. For instance, you have to withhold income tax, social security, and Medicare from the wages you pay them. You also need worker’s compensation insurance and you must comply with employment and labor laws.

When you work with a contractor, you’re entering an agreement that someone will do specific work for a particular amount of money. It can be short-term or ongoing. You don’t have to withhold anything or worry about most employment and labor laws.

However, that doesn’t mean you can run roughshod over contractors. To be able to classify them as a contractor, you give up a lot of control. The right-to-control test makes a big difference in whether the IRS agrees with your classification or not.

Determining If an Individual Is a Contractor

What are the standards used to determine if someone is a contractor? There are several, and the IRS breaks the determination down into three parts.

The first is Behavioral Control. If the business has the right to direct and control the work of the other person, even if they don’t exercise it, that person is an employee. If you tell someone when and where to work, what tools to use or supplies to purchase, or provide ongoing training, that person is probably not a contractor.

Next, consider Financial Control. Does your business direct or control the financial and business aspects of the job? If you reimburse expenses, purchase the worker’s equipment, or don’t allow the worker to profit from their work, they’re likely an employee. If you don’t let the worker provide the same or similar services to others, they are probably an employee.

Finally, there’s the Relationship. A written contract stating the worker is a contractor is not enough by itself to establish they’re not an employee. Employee-type benefits, a permanent relationship, or having the services provided be a key part of your regular business can impact the determination.

As you can see, to classify someone as a contractor, you have to give them a lot of freedom in when, how, and with whom they work. If they don’t have those freedoms, they deserve the protection of being an employee.

Consequences of Misclassification

Unfortunately, some businesses aren’t careful about how they operate and misclassify workers. Many do this by accident, although it may be an intentional attempt to skirt regulations and benefits.

Employers who misclassify are liable for back taxes owed and other penalties. If the IRS or Department of Labor determines that the misclassification was intentional or fraudulent, there can be very high penalties.

Your business could face fines for not filing W-2s, a percentage of wages paid as tax repayment, and a separate Failure to Pay Taxes penalty. Fraud or misconduct raises the fees to 20% of wages paid plus 100% of FICA, and there could be criminal penalties and even jail time.

Right now, companies like Uber and Lyft are fighting significant court cases regarding how they classify workers. In some cases, a business has had to pay over $500,000 in back wages and penalties for misclassification.

You don’t want that to happen to your company—be sure you understand the rules and categorize your workers appropriately.

Take Advantage of Cost Savings Wisely

Working with contractors instead of employees can save you a lot of money, but not if you get caught with the wrong categorization. The fines and fees you’ll pay will far outweigh the short-term savings you might have gained, and your business reputation will take a hit.

Instead, if you want to use contractors, be sure to use them correctly. If you need employees, hire them! There’s certainly nothing wrong with having people dedicated to your business full time.

Many businesses find they work best with a combination of contractors and employees. That may be an excellent option for you as well. Explore your options thoroughly, and you’ll be sure to succeed.

Have questions on your individual situation? Take advantage of a free consultation call with founder and CEO of J. Hall & Company, Josh Hall.