How to Classify Workers: Employee or Contractor?

Every small business begins with just one person or a small team creating a plan and developing a vision. If the company is going to keep growing, however, you eventually need to start expanding your team and invite someone new to join you in your work.

Once your company starts to grow, you won’t be able to hand everything on your own. That’s why hiring your first employee is an essential step for new small businesses.

Not every business follows the same path, however. Not everyone you hire is going to be an actual employee. As your work expands, you can cover your increased need with either an employee or a contractor. The choice you make will depend on what you need and how you want to interact with this worker.

The choice between employee and contractor is about worker classification. What is the status of the worker going to be in relation to your small business?

What is Worker Classification?

Worker classification is about designating a worker’s specific role and status in your company. What are their responsibilities toward you and the business, and what are your obligations toward them?

This process comes down primarily to deciding what category of staff member the worker fits into. This shapes how you’ll supervise them and what your tax obligations toward them will look like.

Categories of Workers:

The two principal categories of workers are employees and contractors. They can also be referred to according to the corresponding tax form you will have to file as the employer: W-2 or 1099.

W-2 Employees

For each employee of your business, you’ll need to fill out and file form W-2, the wage and tax statement. These are staff members with the potential to work for your company for the long-term.

You are responsible for withholding a portion of employee income and paying Medicare and Social Security taxes on their behalf. According to their W-4, you may also pay portions of their income tax in advance. Then you will use the W-2 to report the income they receive and all of the payments you’ve made for them.

Employees can be meaningful team members to invest in. They can take ownership of the work and help you to make the business better.

1099 Contractors

Contractors legally count as self-employed individuals simply working for you on a contract basis. That means they are not subject to supervision and management in the same way that employees are. You aren’t investing in them as a team member so much as you’re hiring them to perform a task.

Your tax obligations are less significant for contractors as well. You don’t withhold any payments for paying taxes. Instead, you provide them with all of their wages directly and allow them to handle the taxes themselves.

You will report contractor wages to the IRS and the contractor using IRS form 1099-NEC, nonemployee compensation.

Statutory Employees

Under certain circumstances, independent contractors can also become eligible for tax withholding and benefits while remaining contractors. These are known as statutory employees because they qualify as employees under particular IRS statutes.

This in-between category includes some salespeople that work on commissions, as well as contractors that make regular use of your company’s tools and resources to do their work.

Why Does Worker Classification Matter?

Worker classification is essential for giving you and your workers clarity about what your expectations and obligations are for each other.

It’s also crucial to understand your payroll tax obligations and ensure you don’t make any unfortunate mistakes. If you effectively treat someone like a full-term employee and expect that kind of work and regularity from them, you can’t play them like a contractor just to avoid the hassle of the extra paperwork.

What’s the Difference Between Employees and Contractors?

Hiring employees may require much more paperwork and commitment, the benefits for your company may be more significant in the long-term. Ultimately, however, it comes down to what your actual business needs are.

There are also several different factors beyond taxes that go into understanding the employee versus contractor designation. Considering some of these may help you discern the right kind of working relationship for your situation.

Behavioral Control

Employers have a degree of authority and behavioral control over their employees in a way that they don’t over contractors. Employees can be trained and taught how to do their job. The employer or another supervisor can then continue to offer specific instructions and feedback about when, where, and how to perform their work.

For independent contractors, however, they simply must finish the promised task. The employer can be very detailed in their initial assignment and evaluation upon receiving the final product. But otherwise, contractors are expected to be entirely self-guided and independent in their work’s day-to-day logistics.

Financial Control

Employers also tend to have more financial control over the work done by direct employees. Employees are paid direct wages, and they work using business resources.

Contractors are more likely to spend their own money in the course of their work, and they may or may not be paid back for it. Contractors are generally paid at a preset flat rate, and the business has no control over how contractors spend money or use resources in meeting their productivity goals.

Contract

The entire relationship between the worker and the employer function differently for employees and contractors. Each position carries with it certain expectations and norms.

Employee positions are expected to be long-term or permanent, and they often include benefits like health insurance and retirement savings contributions. An employee is committed to a company, so the company has certain obligations to care for its employees.

Contractor positions are less stable, and either party can discontinue the relationship without as much warning. There are usually not any significant benefits, either. A contractor is only paid for the work they do. They don’t earn vacation time or sick days. There is also an expectation that a contractor’s job is not central to a company’s functioning.

How to Determine Worker Classification

All of these concerns should determine the decision to hire an employee or contract worker. If the work you need covered is long-term or crucial to your business’s core, you should consider hiring a full employee.

If you already have an employee or contractor, you can also use the criteria above to assess their position and adjust your future plans if necessary. If a position doesn’t match the norms described here, you may also be misclassifying your workers.

If you’re worried about making consequential decisions on your own, work with an accountant and put together a plan for your company’s future. A tax consultant can help your small business consider the financial implications of your hiring plan.