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Updated: March 27th, 2020
Many small businesses are faced with the difficult decision of whether to hire employees or independent contractors. Each type of relationship comes with its own advantages and disadvantages.
Independent contractors (often referred to as “1099 employees”) are individuals or businesses that provide goods or services to another person or business under set terms (usually a limited duration), while exercising independence in how the work is performed. Independent contractors are a great option when your company doesn’t have the resources or need to hire a permanent employee. Advantages can include only having to pay for services as needed, strategically limiting legal liability, not having to pay for benefits and certain taxes, and not having to pay the federal minimum wage (state and local laws may still apply). The disadvantages can include a limited ability to train, a limited ability to control work product, lesser degree of consistency, and potentially weaker intellectual property protection (tip: consider including a “work for hire” clause to your independent contractor agreement if you’re dealing with sensitive intellectual property issues).
Employees, on the other hand, are individuals that are hired by a business to work on a regular basis under direct control and training of that business. Employees are a great option when your small business wants to ensure a certain level of consistency. Advantages can include the ability to train employees, control the work process, and set employee work hours (as long as they comply with wage and hour laws such as minimum wage, overtime pay, on-call pay, etc.). Disadvantages include extra costs (e.g., benefits, taxes, legal liability, work space, etc.), extra structure (e.g., payroll system, tax withholdings, compliance with workplace safety and employment anti-discrimination laws, etc.), and extra management needed to get the most value out of your employees.
Once you determine what type of hiring relationship fits the needs of your business, it is important to make sure that the line between independent contractors and employees is not blurred. If you fail to do so, you can be opening up your business to federal and state penalties/taxes, or even lawsuits for back pay.
Legal classification of a worker as an independent contractor or employee varies between jurisdictions and agencies. For example, the U.S. Department of Labor and the Internal Revenue Service consider different factors in determining classification. The California Department of Industrial Relations and the New York State Department of Labor also consider different factors. While a worker may be treated as a certain classification for taxes, that worker might be treated as a different classification for wage and hour purposes.
Including specific language in a hiring agreement classifying a worker as either an independent contractor or employee is often insufficient by itself. Courts of law and government agencies will look at the actual working relationship between your business and the worker. When managing your relationship with your workers, here are three major areas to keep in mind:
A main factor in determining whether a worker is an independent contractor or employee is the degree of control that you exercise over that worker. The more control you exert over the worker, the more likely that worker will be classified as an employee. Control can take the form of directing the manner in which the work is performed, setting working hours, or dictating work location. While you can set the terms for the type or service you’re willing to pay for, the manner in which the goods or services are fulfilled should be within the discretion of the independent contractor.
As such, the more training you provide, the more likely that your worker will be considered an employee. By training your worker, you are effectively directing the manner in which the work is to be performed. Companies have tried to get creative in the past and work around this issue by making suggestions instead of directives. Companies might send out a weekly newsletter detailing what successful independent contractors have done to be successful in their role with the hope that others will adopt similar behavior. While it may not be a bulletproof method, it certainly is a creative one.
The duration of the relationship between your business and a worker is a factor that is often considered. This includes both the duration of a particular contract and the duration of the relationship between your business and a worker. The longer the duration of a particular contract between your business and a worker, the more it looks like an employer-employee relationship. Similarly, while a worker can be hired repeatedly for multiple projects as an independent contractor, the more structured the work arrangement (i.e., new contract every Friday, etc.), the more likely the worker will be found an employee.
The method of payment is also something to take into consideration. Paying a worker on a regular basis such as on a biweekly pay schedule would tend to show an employer-employee relationship. Paying a worker on commission or contract completion would tend to show an independent contractor relationship.
Exclusivity is probably the easiest factor to determine. The more exclusive the relationship the more likely the worker will be found an employee. If a worker cannot work for competitors while working for your business, then such an arrangement would be characteristic of an employer-employee relationship. If a worker is performing similar work for multiple businesses or advertises his/her services or goods publicly, then such conduct would support the existence of an independent contractor relationship.
Michael Jones is a Senior Editor for Funding Circle, specializing in small business loans. He holds a degree in International Business and Economics from Boston University's Questrom School of Business. Prior to Funding Circle, Michael was the Head of Content for Bond Street, a venture-backed FinTech company specializing in small business loans. He has written extensively about small business loans, entrepreneurship, and marketing.