Contract Labor vs. Employee: What's the Difference?
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Don’t know the difference between an independent contractor and employee? Having trouble understanding the legal implications of the two employment models?
The lines between these two categories can be blurry and whether you're a small business owner or a C-suite manager in a big corporation, it's sometimes challenging to determine what employee type you need for your company.
This article will help you understand the advantages, legal implications, and tax considerations of hiring independent contractor and employees.
What is Contract Labor?
Contract labor is any work completed under individual written contracts, which means that your company doesn’t officially hire a contract labourer. They don’t have a salary, nor do they have employee benefits.
You pay a contract laborer as they complete a job. And once they complete a job, that’s the end of your short-term relationship with them, unless you keep asking for their services.
Many contractors have their own business. This is why the common law considers independent contractors as self-employed, which means that they work for themselves. This also means that federal employment laws don’t cover independent contractors.
Because the Internal Revenue Service (IRS) considers independent contractors as self-employed, they have to pay their own taxes, known as self-employment tax.
If you hire an independent contractor, you have to deduct their wages from your income. You’ll also need to give them a 1099-MISC and the IRS Form 1096 to list how much you paid them.
Here’s a general overview of what contract labor looks like:
- The worker creates their own invoice
- The worker is in control of the hours they work
- The worker typically uses their own tools
- Your company can let the worker go from the position at any time, as long as it doesn’t break the contract
- Your company doesn’t pay the worker benefits, such as health insurance, Medicare, Social Security, worker’s comp, state unemployment tax (i.e. Department of Labor), the Family Medical Leave Act, etc.
Why hire independent contractors?
There are many advantages of hiring an independent contractor. These include:
Cheaper to hire: Independent contractors are typically a temporary solution, and they don’t require a yearly salary or certain expenses such as unemployment insurance. Plus, you won’t have to spend a ton of money on training them and acclimating them to your business operations.
Instant impact: An independent contractor will only be joining your small business for a short period of time. Because they have such a short time with you, they can make a more instant impact.
Flexibility: You’re usually not locked into a long-term project or subject to permanency with an independent contractor. This means that you have the flexibility to make it a short or long-term employment relationship with them.
What is an Employee?
An employee is a worker that's on your company's direct payroll, they work for you full-time, and receive mandatory employee benefits.
You’ll generally provide them with an offer letter or employment contract to specify the terms of their employment. While employees can negotiate their salary, most of them don’t.
You’ll typically withhold federal and state taxes from employees. You’ll also withhold FICA, Social Security taxes, and Medicare taxes. Employees often have rights to benefits, sick time off, vacation, and other job perks.
If you hire an employee, you’re essentially setting out to have a long-term business relationship. And in most cases, within the employment contract, you’re outlining a set amount of hours they should work, whether that’s full-time or part-time. Depending on your company, you’ll either pay employees by the hour or by salary.
In most cases, the employer supplies an employee with the tools and equipment necessary to perform work. For example, you’ll typically supply a phone, computer, laptop, desk, and supplies.
Why hire employees?
There are many reasons to hire an employee. For example, if your company is big on teambuilding, then an employee is the best for that purpose. A full-time employee can help build stronger, more synchronized teams.
Hiring an employee will also make sense if you’re looking for talent that builds familiarity with your business. An employee that gets to know your company is more likely to be more efficient in their work and have a higher job performance.
What are the Main Differences?
So what’s the difference between an employee and an independent contractor? What sets the two types of workers apart? Which one is best for your business?
We answer those questions right here.
Federal and state employment labor laws (i.e. Fair Labor Standards Act) cover employees, but not independent contractors.
A potential employee applies to a job within your company. If your hiring manager or department likes the candidate’s credentials and experience, you offer them the position.
After the employee accepts the job offer, your company might ask them for identifying information, such as their date of birth, marital status, and citizenship status
An independent contractor typically confers with a specific department within your company. The contractor might complete a proposal outlining the services they can provide. Then, the contractor will sign a contract with your legal team.
For tax purposes, an employee will typically fill out a W4 form. Within the form, they’ll provide their name, address, social security number, tax filing status, and their number of exemptions.
As a taxpayer, an independent contractor usually fills out a W9. They’ll write out their name, address, tax identification number, and certification about backup income tax withholding from the IRS.
Reporting to Other Agencies
Employees can receive state and federal unemployment benefits, while independent contractors can’t. However, it's critical to determine the worker's employment status correctly, since the fines following employee misclassification can be detrimental in both financial and legal ways.
Your payroll staff pays an employee based on a strict pay period and when hiring someone on a full-time basis, you typically agree on a gross pay included in the contract. Monetary employee benefits are usually included in the worker's compensation stated in the contract.
On the other hand, accounts payable will pay an independent contractor after receiving an invoice. The contract dictates when and how often you pay them, often on a project basis.
What Qualifies as Contract Labor?
Independent contractor status depends on the type of contract a worker signs with a company. Contract labor is any labor that an employer pays for a project-by-project basis, not by the hour.
Even if you calculated payment based on a certain amount of hours, you’ll still have to pay them the same amount you agreed on in the contract.
How are Contract Workers Paid?
In order for you to pay an independent contractor, they have to fill out a W9 form first. The form will collect their personal information, which you’ll use to report how much they earned for the year.
After a contract worker completes the task you set out for them in the contract, you’ll either pay them by check or via direct deposit.
To pay an independent contractor:
- Make sure you classify them correctly, and determine whether they’re a contractor, freelancer, or regular employee.
- Choose the best payment method and agree on the payment terms.
- Collect the right documents for the IRS.
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If you misclassify an employee as an independent contractor, you could end up owing thousands of dollars in fines and taxes.
Many organizations make the mistake of misclassifying workers because they want to avoid paying the benefits most employees should receive, such as paid time off (PTO), medical insurance, and the employer’s side of payroll taxes.
If you have doubts about whether your contractor may be a disguised employee, you can check out this "economic reality" test provided by the FLSA to determine if you comply with all the rules.
How to Convert a Contractor into an Employee
So maybe you’ve worked with a contractor several times. And now you want to fully hire them on to your company. There’s a process to converting a contractor to an employee. It usually goes like this:
Determine the Worker Status
Before trying to switch a contractor to a full employee role, determine their employee status. To do this, you should file a form SS-8 a fuse the IRS three-prong test.
Here’s what the test covers:
- What degree of control do you have over the worker’s behavior?
- Do you have financial control of the worker?
- What’s the duration of your relationship with the worker? What type of relationship is it?
If you determine that you can convert the contractor into an employee, switching from Form 1099 to Form W-2.
Notify the Worker of the Change
Make sure the worker knows that you switched them from an independent contractor to an employee. Ideally, you want to tell them in writing. It’s easier to track a written memo than it is to track a verbal message.
Keep in mind that independent contractors value their freedom. So, be sure to offer them a competitive benefits package that’s hard to turn down.
Make the Necessary Adjustments for the New Employee
Make your new employee feel welcome in your company. You can do this by introducing them to the rest of the team and putting them through the onboarding process. Also, you might consider assigning them a mentor to help them adjust to their new role and learn how things work for full-time employees.
Add the New Employee to Your Company’s Payroll
Get with your HR department to collect all the necessary information and store it in the new employee record. You’ll no longer be paying your new employee through a W9. So make sure you’re implementing this change when you add them to payroll.
Fast and Easy Hiring with Deel
Understanding the nuances of hiring independent contractors isn’t as simple as you might think, especially when hiring overseas.
That’s where Deel can step in. Our solution can help you stay compliant when hiring around the globe and avoid mistakes when hiring overseas.
We’ll make sure you have the right documentation in place to reduce your legal and operational overhead. For more information on how we can guide you through compliance matters, request a demo today.