Employees vs. Contractors: What Entrepreneurs Should Know

Every entrepreneur needs to understand how to classify their employees and independent contractors. This is especially true if you own a startup or small business, and is even an important consideration for freelancers hiring subcontractors.

In this (kind of long) guide we will dive into four topics:

1. The differences between employees and contractors
2. How that difference impacts your tax obligations
3. Intellectual property considerations
4. Other considerations

1. The Differences Between Employees & Contractors

When you hire someone, they will be classified as either an employee, or an independent contractor.

With employees, you’ll have more control, but more compliance obligations. With contractors, you’ll have less compliance obligations, but less control.

In the end, it doesn’t really matter what you say, it matters what the IRS says. So how do they make the determination?

The IRS Factors

• Performance. If you exert a lot of control over your worker (such as when, where, and how they work), then the worker is more likely to be an employee. If your worker chooses when, where, and how to work, then the worker is more likely to be a contractor.
• Equipment. If you provide equipment (tools, computers, etc.) for your worker, then the worker is more likely to be an employee. If your worker provides their own equipment, then the worker is more likely to be a contractor.
• Payment. If you pay a worker on a regular, ongoing basis (especially without a termination date), then the worker is more likely to be an employee. If you pay a worker on a project-basis, even if the payments are in milestones, then the worker is more likely to be a contractor.
• Benefits. If you offer the worker employment-style benefits (like health care or PTO), then the worker is more likely to be an employee. If you don’t offer the worker benefits, then the worker is more likely to be a contractor.
• Term & Termination. If either party can terminate the relationship at any time, for any (legal) reason, then the worker is more likely to be an employee. If the parties’ termination rights are subject to a contract, then the worker is more likely to be a contractor.

2. Your Tax Obligations

To keep things simple, you should just know that the IRS (and in many cases, state and local governments) will collect a portion of wages paid to someone in exchange for their services to cover income taxes and employment taxes (medicare and social security). But how that works is dependent on how the worker is classified.

Employees

When you hire an employee, your business must (a) withhold portions of their wages (for the employee’s income taxes and their share of their employment taxes); (b) remit those withholdings to the government on a regular basis; and (c) pay your share of the employee’s employment taxes to the government. In some situations you’ll also have to pay into workers’ compensation funds and pay additional unemployment taxes.

Due to the withholding and other requirements, it is usually best to use a payroll provider or cloud-based platform to help you manage the process. We use gusto.com and really like the platform (that’s our referral link).

In total, you should anticipate paying 10%-12% more in taxes and similar expenses when hiring employees as compared to contractors.

Contractors

Things are quite a bit easier when you are paying a contractor for services because the contractor is responsible for withholding and paying all of their taxes. Further, you can usually avoid workers’ compensation and unemployment tax obligations with respect to contractors.

However, if you pay a contractor who is taxed as a pass-through entity more than $600 in one year, then you need to use W9s and 1099s for that contractor:

• Background: Since you don’t have to do withholdings when you pay a contractor, it’s entirely possible that the contractor could hide the payment from the IRS. That’s why we have W9s and 1099s.
• IRS Form W9: Always ask your contractors to give you a W9. It’s a simple form that the contractor will use to give you their legal name, address, SSN/EIN, etc.
• IRS Form 1099: With the W9 in hand, you can then complete a 1099 at the end of the year. You’ll enter in the contractor’s information and how much you paid them and you’ll give a copy to the IRS (and another copy to the contractor). The IRS will then use that information to make sure the contractor reports the payment on their tax return.

Also note – if you operate as a pass-through entity, then you’ll have to give a W9 to any client which pays you more than $600 in a year.

3. Intellectual Property Concerns

If you hire someone to create something for you, you probably want to own the intellectual property rights to the creations. If so, then you need to pay special attention to this section.

Employees

Generally speaking, your company will own the intellectual property to anything that your employee invents or creates if the work is within their scope of employment, is created on your time, and with your equipment. Even though that is the default rule, it is always a good idea to have something in writing with your employees to clarify that your company will own their inventions and creations.

Contractors

Things get more complicated when you hire independent contractors. Generally speaking, the contractor will own the intellectual property rights to anything they invent or create, even if you pay them. That’s why it is critical to get an assignment in writing. For certain creative works, you can designate the works as “works made for hire” in the written agreement to ensure copyright ownership vests in your company. But for all other works (and as a backup measure for works made for hire), you should use an explicit assignment of intellectual property rights in your written contractor agreement.

4. Other Considerations

Regardless if you hire employees or independent contractors, you should consider a few additional legal protections:

• Written Agreements. You should always use written agreements with your independent contractors. You can also use written agreements with employees, but they are not as important there. But if you don’t use them, you should at least have an employee handbook (or something similar) which they sign to protect you in certain areas (see the next few points).
• Confidentiality. It is always wise to use non-disclosure agreements with your employees and contractors. The NDA should require them to protect your confidential information and prohibit them from disclosing or using your information without your consent.
• Non-Solicitation. You might have your employees and contractors sign a non-solicitation to prevent them from soliciting your employees and clients while they work for you and for a period of time after they stop working for you. Learn more about non-solicitation agreements here.
• Non-Compete. You might have your employees (and maybe contractors) sign a non-compete to prevent them from competing with your business while they work for you and for a period of time after they stop working for you. Learn more about non-compete agreements here.

(This article is general in nature and is not legal advice.)