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Contractors vs. Employees (Differences) – Who Should You Hire?

When a small-business owner decides they need more help, the next question is whether they should hire employees or freelancers. The decision can be difficult — especially if you’re working with a limited budget.

To help with your decision, we’ve outlined the legal differences between freelancers and employees, and some tips for deciding which type of help you need.

Freelancer vs. Employee: What’s the Difference?

There are significant legal differences between hiring an employee and bringing on a freelancer or independent contractor.

Employee Contractor
Taxes Employers are responsible for withholding income tax, Social Security, and Medicare from an employee’s wages. Freelancers are responsible for paying their own income and self-employment taxes.
Employment Laws Employees are covered by several federal and state employment laws, including minimum wage and overtime regulations. Although it isn’t true in all states, freelancers are typically not covered by most employment and labor laws.
Benefits Employers may be required to provide vacation, holiday, and sick pay to full-time employees. Employers are not responsible for providing paid vacation, holidays, or sick pay to freelancers and independent contractors.
Insurance Employers may be required to purchase workers’ compensation insurance and pay unemployment insurance taxes. Employers are not required to purchase workers’ compensation or pay unemployment taxes on freelancers.

Can I Classify My Employees as Independent Contractors?

Many small-business owners review the table above and assume hiring a freelancer is the way to go. After all, when you hire an independent contractor, you aren’t responsible for things like tax withholding, benefits, and insurance as you are when you hire an employee. However, the IRS has rules about whom you can treat as an independent contractor. You can face some pretty stiff penalties if you misclassify employees solely to avoid taxes.

According to the IRS, there are three factors involved in whether a business should classify a new hire as an employee or a freelancer.

  1. Behavioral Control. An employer has the right to direct and control work performed by an employee, such as dictating when or where an employee must work, or what tools or services they must use. However, a business owner cannot determine how an independent contractor works, only the desired results of the work.
  2. Financial Control. An employer has a right to direct and control the financial and business aspects of an employee’s job. For example, an employer can mandate an employee cannot have a second job or start a side business that competes with the employer’s business. Freelancers and independent contractors are generally free to work for other clients and seek out other business opportunities.
  3. Relationship. An employer-employee relationship typically continues indefinitely, while the relationship between a business and a contractor usually exists for a specific project or period. It’s good to have a written contract between the company and the contractor that states the worker is an independent contractor. But it’s not sufficient on its own to determine the worker’s status.

Should I Hire a Freelancer or an Employee?

Aside from the IRS rules, think about your business needs when deciding whether to hire an employee or freelancer. The questions below will help you work through the decision-making process.

1. Do You Need Long-Term Support or Help on a Short-Term Basis?

If the work to be done is just a short-term project, you may want to hire an independent contractor. For example, if you need help building a website, but you won’t have much work for a web developer once your site is up and running, that’s a good project for a contractor that you find from a platform like Fiverr.

On the other hand, if you need ongoing help fulfilling and shipping customer orders, you may be better off hiring an employee.

Pro tip: If you’re planning to hire full-time employees, start your search with ZipRecruiter. Their technology will scan thousands of resumes and find the perfect candidates instantly.

2. Is the Work Part of Your Core Product or Service?

If the work to be done supports your business but is not a part of your core product or service, you may be better off hiring a freelancer. For example, you might outsource monthly bookkeeping to an independent contractor. However, if you need someone to handle customer service for your products, you’re better off hiring an employee.

Highly skilled freelancers are often busy, and they might not have time to work on your project at the drop of a hat. So if you have a regular and consistent need for someone to do work on your timeline, an employee is the way to go.

3. Can You Afford an Employee?

It’s easy to predict and control the cost of hiring a contractor by negotiating a flat fee or hourly rate. Beyond that agreed-upon compensation, there are few if any additional costs.

Hiring an employee is often much more expensive. Salary is just one component of the cost of hiring. You also have to plan for taxes and other government-mandated expenses, buying supplies like desks and computers for them to use, employee benefits, and how you’re going to calculate their paycheck with all the withholding you have to do.

  • Payroll Taxes. After salary, payroll taxes are usually the highest cost of hiring an employee. They include the employer’s portion of Social Security and Medicare taxes and federal and state unemployment taxes. ADP maintains a database of applicable payroll taxes by state to give you an idea of what it costs to hire an employee in your location.
  • Benefits. Providing employee benefits like health insurance, disability and life insurance, and retirement plans can cost anywhere from 20% to 40% of an employee’s gross salary.
  • Workers’ Compensation. Most states require a business to purchase workers’ compensation insurance as soon as they hire an employee. The cost of obtaining workers’ compensation depends on your state and the type of work the employee performs.
  • Payroll Processing. When you pay a contractor, you cut them a check for the amount you owe. But paying an employee means calculating and withholding payroll taxes, sending those taxes to the state or federal agencies, and preparing quarterly payroll tax returns. Most businesses outsource this task to a third-party payroll provider like Quickbooks Payroll. The cost of outsourcing payroll depends on the level of service required and how many employees you have but typically costs at least $15 to $20 per month.
  • Tools and Equipment. Generally, contractors are responsible for providing their own computers and any necessary tools and equipment. But employers are responsible for providing necessary equipment and supplies for employees. Depending on the type of work you expect your employee to handle and where you want them to do it, you may have to provide office space, a desk and chair, a computer, a phone, and other equipment and supplies.

Final Word

Deciding between hiring freelancers or employees can be difficult, but it doesn’t have to be. If you need flexibility, low cost, and skills that fall outside of your typical scope, a freelancer is the way to go. If you need regular help, have more room in your budget, and want someone available on a regular basis, hiring a full-time employee is the best choice.

Have you hired a freelancer or employee in your business? How did you decide which one you needed?

Janet Berry-Johnson
Janet Berry-Johnson is a Certified Public Accountant. Before leaving the accounting world to focus on freelance writing, she specialized in income tax consulting and compliance for individuals and small businesses. She lives in Omaha, Nebraska with her husband and son and their rescue dog, Dexter.

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