Independent Contractor vs. Employee: A Detailed Breakdown of Costs and Business Needs
We work with small businesses ready to expand and grow their business by growing their team. That is why we get asked A LOT, should I hire an independent contractor or an employee? The Answer:
It depends.
Below we share with you the practical specifics of hiring, paying, and working with both employees and contractors so you can choose the right option based on your business needs. Here is an outline for the subject matter and how we present these options to our clients:
What’s the Difference Between Independent Contractors and Employees?
In a ‘working relationship’ lines between independent contractor and employee can be blurred; but the distinction is really important to get right.
According to the Internal Revenue Service (IRS), a worker is an:
Employee if: You can control what will be done and how it will be done. This is so even when you give the employee freedom of action. What matters is that you have the right to control the details of how the services are performed.
Independent contractor if: The payer has the right to control or direct only the result of the work and not what will be done and how it will be done.
In both definitions, the idea of control is the primary distinction between a contractor or employee. The IRS breaks their criteria down into three categories:
Behavioral Control: Do you decide how, when, or where a worker does their work?
Financial Control: Who decides on payment terms and methods—you or the worker?
Type of Relationship: Who decides on the employment agreements, contracts, and the length of time you are employed?
Further, many states use the federal designation as a start, then consider how economically dependent the worker is on the company as a further test.
Why the Distinction Matters
While there is a lot of ambiguity between independent contractors and employees, taking advantage of that ambiguity by classifying legitimate employees as contractors—to avoid paying employment taxes and having to provide benefits - can result in harsh penalties. For an example, Uber settled a labor dispute in early 2019 by agreeing to pay out $20M to affected drivers, after six years in court. The lawsuit claimed their “independent” drivers are actually employees because of the degree of control Uber exerts over how, when, and where they work. If you’re uncertain about someone’s classification, here are some resources that offer more information about federal and state classifications:
Understanding Employee vs. Contractor Designation│U.S. Internal Revenue Service
What You Need to Know About Hiring Independent Contractors│LegalZoom
State Department of Labor Offices│U.S. Department of Labor
Form SS-8: Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding│U.S. Internal Revenue Service
Costs of Hiring an Independent Contractor vs. Employee
It’s tempting to think that one type of worker costs more than the other. The reality is a little more involved and it’s difficult to compare the costs side-by-side. However, we have taken a look at the type of costs that come with hiring contractors and employees and presented this below:
For independent contractors, it’s often straightforward—you pay an agreed-upon hourly or project-based fee. While there can be some variation in your final bill, most of the time you know what to expect.
NOTE: Good contractors often charge higher rates because they have to pay for their own self-employment taxes and benefits. If you only need a few projects done, a high-quality contractor can be less expensive than an employee. But if you have many projects in mind, an employee may be most cost effective.
For full-time or part time employees, There are myriad costs, including:
Hourly or Salary Compensation (with possible bonuses). MIT estimates the true cost of an employee is 1.25 – 1.4 times higher than their salary.
Benefits & Payroll taxes - take a look at the QuickBooks Employee Cost Calculator to input the specific benefits you plan to provide along with base pay to determine roughly how much it will cost you. See below for additional detail.
Job training
While it may seem like it costs more to hire an employee, keep in mind that many contractors often charge a higher per hour rate to account for self-employment taxes and benefits.
Comparing Costs by the Hour: Dependent on our clients, we break the costs work down to an hourly rate by finding the average salary in the area for the job role, then multiplying that by 1.3x to get the ‘true cost’ of the employee, then dividing that number by 2,080 hours per year (for a full-time employee—that’s 40 hours a week, for 52 weeks in a year) to get the hourly rate. This exercise will help you understand whether you can get quotes from contractors with a similar level of experience to outsource work or hire for within the company.
Employment Taxes, Benefits, and Other Expenses
Employment Taxes: For employees, you are required to pay Social Security and Medicare taxes (FICA) and unemployment taxes (FUTA and SUTA) —and you are responsible for withholding the employee’s portion of income taxes and remitting it to the appropriate tax agency. You’ll need a software solution or an accounting professional to help because running payroll and remitting those taxes is a complicated process. If you can’t afford to build out the infrastructure that managing payroll requires, then it is likely that you cannot afford an employee.
Other Expenses: you may encounter in hiring employees can include the cost of recruiting, job training, and ongoing training and development.
Note: Some people think that part-time employees are a happy medium when it comes to costs. That said, requirements around part-time workers vary widely from state to state—so if you’re considering that route, we recommend talking to an employment lawyer or other business professional to learn more about your obligations.
Benefits: Federally mandated benefits include:
Health insurance
Overtime pay
Unemployment insurance
Worker’s compensation insurance
Unpaid, job-protected family and medical leave
Additionally, your state or city may require you to offer additional benefits, including:
Dental and vision insurance
401(k) plans and contribution matching
Paid time off (including vacation, sick leave, and family leave)
Disability insurance
Many of these benefits are commonly offered to employees throughout the U.S. — even where they aren’t required — along with other fringe benefits and perks (like commuter benefits or professional development stipends).
Employee Relationship and Type of Work
Costs aside, there are some situations clearly more suited to an independent contractor versus a full-time employee. Here’s a quick look at situations that may affect your choice:
Independent contractors can be a good solution if the work you need done is:
A short-term project (like a new product launch or a website redesign)
Specialized and transactional (you won’t need to coach the contractor through each step)
Outside your core business offering
Because of that, independent contractors are most often hired to do work like building your website, writing your blog content, and handling administrative tasks. They may also be ideal for seasonal work, but that really depends on how much control you need to have over their work process (more on that below).
Employees can be a better option if the work is long-term and ongoing, central to what your business does, and highly collaborative. Employees can handle multiple projects at the same time and you don’t have to get them up to speed before each and every undertaking. That, in itself, can make employees more cost (and time) effective in the long-run.
Degree of Control: How, Where, and When Work is Done
While control may seem cut and dry, it’s a really important consideration to factor in before you choose between an independent contractor or employee. Otherwise, you may exert too much control over how a contractor works and end up in hot water with the IRS or the Department of Labor. The general rule is this:
For Independent Contractors: you can specify the end product and a deadline for it. You can’t mandate things like where a contractor works or the hours they keep.
For Employees: you have much more control over how, when, and where that work gets done. That’s part of why highly collaborative work tends to be done by employees—because you can mandate they come into the office and work the same hours as the rest of your team.
On the other hand, asking that of employees means you’re responsible for providing them the tools to work in that way, including office space, computers, and training. That can drive up the ultimate cost of hiring someone.
Independent Contractor vs. Employee: Which is Right for You?
Which type of worker makes sense—both for your business in general, and for each individual role you need filled—depends on many factors. It comes down to taking an honest look at your budget and your current and future projects. With some time, research, and thought, you’ll be able to determine the right type of worker for your unique situation. Hopefully this post helped you kickstart the process and if not book a session with us and we will help you in the right direction. Below is a quick cheat sheet for you.
