Putting together the right team when you’re starting and growing a small business can be a daunting task. And having to choose between hiring contract vs. full-time workers introduces a whole new set of factors to consider.
To resolve the confusion and help you choose the best hiring option for your business, this guide will clarify the differences between contractor workers and full-time employees so you can decide which is your most cost-effective option.
Contract vs. full-time workers
The classification difference between contract vs. full-time employees is vital. Generally, you can think of a contractor as providing services for you, but who’s working independently and pays taxes on money they receive from you. An employee, on the other hand, is on your team — you’re their supervisor, responsible for their behavior and also reporting their taxes.
Many businesses, both small and large, have made the mistake of misclassifying employees — and have paid the price in hefty fines, legal fees, retroactive payroll taxes as a result. Although the IRS has no absolute definition of either the independent contractor or the W2 employee, they do have a 20-point checklist to determine employee status.
Independent contractor (1099)
Think of an independent contractor as a separate business entity. The contractor provides a service for which you pay. You enter into a contract with the 1099 employee after agreeing on the parameters of the project and the fee for services rendered.
You can then expect that the contractor:
Pays all taxes on payment received from you — federal, state and local, including Social Security and Medicare.
Provides all supplies and equipment needed for the service provided.
Works based on a short-term contract or project-by-project basis.
Will invoice you and expect to be paid according to the terms of the contract — usually at the end of satisfactory completion of the project.
For simplicity’s sake, think of your independent contractor as just that — an individual who’s providing a service to your business (either one-time or ongoing), but who’s ultimately independent of your business and its day-to-day operations.
Full-time employee (W2)
If the work that an individual does for your business — whether on a full-time or part-time basis — requires that you dictate when, where and how they perform their duties, chances are that the IRS would classify this individual as a W2 employee.
This type of working relationship tends to be longer-term, with you as the employer continuously supervising the team member, directing and overseeing how their work is performed.
Circumstances around taxes are different, too: When a worker is classified as a W2 employee, you as the employer are required to report and pay payroll taxes on the individual. This is one reason that the IRS pays close attention to employee misclassification.
Not sure whether workers on your team should be classified as employees or individual contractors? From a work product and process perspective, the IRS will consider:
Behavioral control: Do you dictate the worker’s method and schedule for performing tasks?
Financial control: Do you dictate hourly and/or salary pay rates? Do you handle payroll taxes, including Social Security and Medicare? Do you control benefits available, such as vacation and sick days?
Relationship: Does this person’s job involve developing ongoing relationships with co-workers as well as customers/clients?
If you answered yes to one or several of these questions, it’s likely that, from the IRS’s perspective, your worker should be classified as a W2, or full-time employee.
Costs of contract workers
With a good grasp of the IRS-defined differences between 1099 contract workers and W2 employees, let’s take a closer look at the cost factor of contract workers vs. full-time employees. Will a 1099 independent contractor actually cost you less in the long run?
The answer is that it depends on your business’s needs.
Because, in reality, the hourly or flat-fee rate that you pay for an independent contractor will most likely be higher than you’d pay an employee to perform the same services. However, that’s mostly due to the additional costs you’d normally incur with an employee that aren’t required when you hire an independent contractor.
How payment works
Although quite different from the traditional payday-every-Friday model, the payment process for independent contractors is simple for the small-business owner.
In general, independent contractors are paid a flat fee for services rendered. This fee is agreed upon by the business owner and contractor after they’ve both also come to terms on the specifics for the project, but prior to work kicking off. (You don’t want to get caught up in any miscommunication about either amount of money or scope of work — that’s for sure.)
Both parties agree on how the fee will be paid, but it’s usually paid at the end of the contract when all the work has been completed to the satisfaction of the business owner. Sometimes, a contract worker will request a deposit or a portion as a retainer. Most commonly, though, you’ll see an invoice from a contractor at the end of a project.
You can typically expect to pay more upfront; however, keep in mind that contract workers are fully responsible for their own expenses, including all taxes. This means you have no obligation for federal, state or local taxes, Social Security or Medicare benefits, worker’s compensation insurance or unemployment taxes. All tax filing is the responsibility of the contract worker.
As the employer of a 1099 contractor, your only responsibility is to pay the contractor’s fees as invoiced, then supply a Form-1099 each January detailing payments made.
The hidden costs
Beyond the simple facts of when and how money changes hands, tax withholdings and other surface-level costs, working with contract vs. full-time workers will involve additional management and opportunity costs that might be less obvious.
As you weigh whether contract or full-time workers will be the best choice for your business, don’t overlook the financial impact imposed by these realities of working with independent contractors:
1. The contractor’s timing may not match yours. By law, contractors have the right to dictate their own working hours. Many freelance independent contractors work part-time or non-traditional hours, and most work for more than one client at a time.
For this reason, your time frame and desired schedule may not necessarily be achievable when working with independent contractors. It might be necessary to either adjust your project timetable (which could cost you time and money) or hire a different contractor to complete the full scope of work on a given project.
2. Contractors are legally limited to 1,040 hours of work annually. According to IRS and common law, an independent contractor can only work a maximum of 1,040 hours (equivalent to approximately six months of full-time work) annually for a single employer.
To fulfill these conditions, you might find yourself spreading a single job between multiple workers or even letting go of one contractor to hire another if you hit this limit before the end of a given project. Imagine the time it takes to bring someone up to speed… and then having to do it again.
3. Contract workers will have less loyalty to your company. It isn’t unusual for an independent contractor to be working on projects for several clients at any given time. Frankly, they generally have to in order to make ends meet; simply by virtue of being independent, the contractor is likely to hold less loyalty for any single company.
When another client offers a better fee for the services being rendered, there isn’t a guarantee that your favorite contractor won’t leave you and go to your competitor for higher pay. As a result, there can be little to no expectation of a long-term working relationship with your contractor, and you will always need a plan in place for how you will proceed if the contractor becomes unavailable.
Costs of W2 employees
As a small-business owner, you have reasonable control over most of the expenses associated with your W2 employees. You control the pay scale and benefits offered, the work schedule, the supply requisition and purchasing, and the training budget.
Keeping these administrative controls in mind, let’s take a closer look at how a W2 employee may or may not be the best financial choice for your business:
How payment works
Full-time W2 employees are paid in the traditional way. Hourly employees typically work a preset schedule, then punch a time clock or use a timesheet to log hours. Salary employees might be paid a set amount per period, regardless of the exact number of hours they work. Either way, however, both employee types will receive their paycheck in accordance with a consistent weekly, bi-monthly or monthly schedule.
With each paycheck, W2 employees will have a predetermined proportion of income taxes automatically withheld, as well as any other benefits for which they’ve authorized payment. For the most part, these employees won’t have to think about taxes again until filing their annual return each April, when employees might be entitled to a refund based on the amount withheld from their regular pay.
The unexpected extra costs
Just as with independent contractors, there are hidden costs that businesses incur as a result of W2 employees. Some of these are a little more obvious because they are actual expenses. However, all will factor into your decision as to whether contract or full-time workers are best for your business.
1. Providing supplies and equipment to operate efficiently. One of the biggest differences between independent contractors and full-time W2 employees is who pays for all the supplies. For the W2 employee, the business either directly pays for or reimburses the employee for all supplies needed to complete the job efficiently.
The business also provides necessary office space and equipment to ensure that the employee can be effective in his or her job performance, including furniture, technology and other equipment needs. This is a required cost of hiring W2 employees, regardless of whether employees work on-site or in a remote capacity.
2. Training and professional development. In order to stay current in the marketplace, businesses must grow and adapt to a changing landscape on a regular basis. Providing training or education stipends for new and existing employees is essential in giving them the best opportunity to be successful at their jobs over the long term.
3. Maintaining a positive company culture. In the long run, most quality workers are motivated by far more than a regular paycheck (clearly — since so many workers ditch steady work to become independent contractors, or start their own small business). This means keeping long-term employees enthusiastic about the business is critical to ensuring that not only do they keep contributing — but that they stick around, period.
Choosing between contract workers and full-time employees
Now, the big question: Should your business hire contract or full-time workers? Which is the most cost-effective choice? The answer could be either or both, depending entirely on your business’s needs at any given time.
When to choose an independent contractor
For projects or tasks that have a short projected completion time and don’t require much supervision, independent contractors work well, leave you with less long-term obligation and tend to be generally more cost-effective.
That’s because you only hire independent contractors when you actually need them, they tend to be more current on the latest technologies and trends, and they offer diverse work experiences.
After all, training any new worker requires time and funds — and these are two things small-business owners don’t always have an abundance of on hand. In fact, you may not even personally have the skills to train an employee in the tasks required for your business. For this reason, independent contractors tend to be the best choice if you need specific expertise for a project in a short period of time.
Here are a few specific scenarios in which an independent contractor will likely be the more cost-effective choice for your business.
Expert competencies: Website design/development, online marketing, copywriting, data mining, software programming, etc.
Seasonal projects: Help with order fulfillment or customer service during particularly busy times for your business.
Administrative or bookkeeping services: When you need someone to help with basic administrative or bookkeeping tasks for just a few hours per week. These jobs require very specialized skills, can be done remotely and typically don’t offer enough hours to be worthwhile for a part-time W2 employee.
Building and equipment maintenance: Heavy-duty maintenance that must be done on equipment or facilities on an infrequent, as-needed basis.
When to choose full-time W2 employees
Choose W2 employees with an eye on the future of your small business. Of course, you have a position to fill now and you certainly want to choose carefully to find a good fit. However, you also have to consider how this person will fit into the business model in the future.
One of the advantages of W2 employees is that they tend to create a sense of community within the workplace. Long-term employees often feel they have a personal stake in the success of the company and become great word-of-mouth marketing tools.
As a small-business owner, you’ll find that W2 employees are:
Especially helpful for success in local markets. When they already know the target market and could have important contacts they can leverage for business growth.
Better for projects that require close supervision. Since W2 employees have regular pre-set hours, it’s far easier to use them for projects and operations that require timely reporting and close supervision.
Essential when the need arises for developing relationships. As W2 employees are in-office daily, they’ll have a better feel for what’s happening within the business than an independent contractor who works remotely would.
This knowledge gives the W2 employee the edge on nurturing relationships with customers or clients that can be invaluable in the long term.
A version of this article was first published on Fundera, a subsidiary of NerdWallet.