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Contractor vs. Employee: An Explainer for Small Businesses

A young man in a knit cap and wearing glasses sits at a cafe looking at his laptop. His left hand is raised to his face, like he's thinking. He is moving his right index finger on the touchpad of his laptop. To his left, here's a mug likely filled with coffee and a glass bottle of water as well as an empty drinking glass. The young man is the type of worker that might make a business work through the contractor vs. employee analysis, to make sure he is being paid correctly.

Having employees can get expensive. You have to pay all sorts of extra taxes and insurance. We covered the nitty gritty of these extra costs in our how to hire employees article. Independent contractors, on the other hand, are easy. You just pay them for the job. So why don’t more businesses use contractors? Because the law that deals with contractors vs. employees can get complicated too. And you can be fined, sometimes heavily, if you misclassify an employee as a contractor.

So, how do you stay on the safe side of the contractor vs. employee divide but still use contractors as much as you can without getting into trouble? Sadly, there’s no easy answer. The federal government and the various states use different tests to categorize a worker as one or the other. We’ll give some guidance below to help you stay on the safe side by as much as possible.

Please note that this article only covers how US agencies classify employees and contractors. If you live in another country, please check your country’s laws to make sure you use the correct tests.

Independent Contractor vs. Employee: What’s the Difference?

If they each stayed in their lane, there’s actually quite a lot of difference between an independent contractor and an employee. In general, an independent contractor is running their own business, and they provide you with a service as a business. An employee, on the other hand, is a person who you pay to do whatever you need them to do to run the day-to-day of your business.

Typically, you work with a contractor one project at a time. You both agree on the scope of the project, the deliverables, the due date(s), and the quality of the deliverables. You don’t have control over when the contractor works on your project. The contractor is often free to use their own employees or subcontractors (unless you agree to something different in the contract). They provide their own equipment. You pay the contractor per job. And, if the contractor doesn’t like the project, the pay, or both, they can turn the project down.

You have much more control over what, when, and how your employee does their job. Typically, you hire an employee for a specific job. But, you can switch them to another job later on, if you wish. If you want to micromanage your employee, you can (though we don’t recommend it). You typically provide the employee all the equipment they need to do their job. The employee usually just has to show up for work at the time you designate and be ready to work at a job you designate. You can pay an employee per hour or with a salary.

On a high level, it’s pretty easy to tell who is a contractor and who is an employee.

The Costs of Using Contractor vs. Employee

Because a contractor is a separate business, you won’t have to pay a lot of a contractor’s overhead like you’d have to pay for an employee. You also won’t have to worry about minimum wage calculations, unemployment insurance, or worker’s compensation insurance.

However, to make up for the difference, a contractor’s effective hourly rate is often higher than an employee’s hourly rate. But, unlike with employees where you have to pay them if a project takes longer to complete than expected, a contractor must typically eat project overage costs.

Some of the costs you’d have to pay for an employee but not for a contractor include:

  • Overtime payment
  • Unemployment insurance
  • The employer’s share of their Social Security and Medicare withholdings
  • Worker’s compensation insurance
  • Any other additional state or local taxes or withholdings
  • Costs to comply with legal requirements such as OSHA, immigration, ADA, and similar regulations
  • Healthcare costs (if you offer it)
  • Paid vacation (if you offer it)
  • Retirement benefits like 401k matching contributions (if you offer it)

What Types of Projects are Suitable for Contractors?

Typically, you use contractors for discrete projects. This doesn’t mean that you have to use them once and wait a while before you can use them again. You can use them continuously, but there’s always a definite start and end to a project. There’s also never a guarantee that you will always send them new projects.

Here’s an example of discrete projects that you can hire a contractor for, but can also keep using them for a long time. Let’s say you hire a contractor to build a website for you. There’s a final product they’re supposed to deliver as well as certain quality standards they have to hit. While you get to approve each phase of the project, you don’t get to helicopter over them as they work. Once they finish building the website, they’ve finished the project.

But this doesn’t have to be the end of your working relationship. You might hire them to maintain the website. In that case, you might negotiate a monthly fee for a standard set of work they’ll do. The contract might be month-to-month or for a year and the contract automatically renews. The fact that they continue to do work for you doesn’t necessarily mean that they’ve suddenly become your employee.

As long as you can fit the work into such a pattern, the work might be suitable for a contractor. Your contractor will usually invoice you each month, and you pay them based on the invoice.

If you’re interested in hiring contractors, we have a series of articles on how to scope out projects for contractors and on where you can find contractors. Here’s the link:

Finding a Freelancer or Contractor, for Startups

There are Several Tests for Deciding Between Contractor vs. Employee

So far, we’ve tried to give you a gut feel on the difference between a contractor and an employee. But, formally, there are several tests under the law to distinguish between the two. Different government agencies—both state and federal—use different tests. And the tests won’t give you a bright line answer either. So, always be careful when applying the tests to your situation.

The two tests used to distinguish between a contractor and an employee are generally known as the ABC Test and the Common Law Test. We go over both below.

The Common Law Test

As of this writing, a minority of states use the Common Law Test to decide if a worker is an employee or a contractor. But the IRS also uses this test to decide if you have to pay the worker’s unemployment taxes and Social Security and Medicare withholdings. Not only that, the Wage and Hourly Division of the Department of Labor, which oversees minimum wage and overtime payments, seems to use the Common Law Test as well. (Technically, their rules are in flux, but it seems that they’re reverting back to the Common Law Test after trying to change the rules back in 2021.)

So, basically the Common Law Test applies to all employers in the country. The only question is that, in addition to the Common Law Test, if you need to apply the ABC Test as well.

How to Use the Common Law Test

The Common Law Test is a multi-factor test. The factors are not always given the same weight. So, you can’t count factors and decide if the worker is an employee or a contractor. (E.g., you can’t say a worker is a contractor because 6 factors say they’re an employee and 10 factors say they’re a contractor.) Instead, you have to decide by looking at the overall circumstances.

To use the Common Law Test, you first look at the three major categories under the test. Then you evaluate various factors within each category to decide if the category leans more towards contractor or employee.

The Factors of the Common Law Test

Here are the categories and factors of the Common Law Test:

  • Behavioral control
    • Employee: told when and where to work, types of tools to use, and where to get supplies; told how to complete work; evaluated on how they do the work; more training needed to be able to do the job.
    • Contractor: decides when and where to do work; buys own supplies; less instructions on how to complete work; evaluated on results; less training needed to be able to do the work.
  • Financial control
    • Employee: paid by the hour or salary; often only works for you; often reimbursed for work-related expenses.
    • Contractor: decides which equipment to buy to do the work; expenses not reimbursed (typically included in the contract price); paid per project; might make a profit by being more efficient; can do work for others while working on your project
  • Type of relationship
    • Employee: no employment contract; expectation to continued to be employed; gets benefits like paid vacation, healthcare, paid sick leave, etc.; works on the primary service provided by the business
    • Contractor: usually works through a contract; no benefits; no expectation of continued work once contract ends; often doesn’t provide the primary service provided by the business (e.g., if business is package delivery, employees—not contractors—are the delivery drivers).

The ABC Test

A slight majority of the states use a variation of the ABC test instead of the Common Law Test to decide if a worker is an employee or a contractor.

In general, the ABC test is a more stringent test. The worker is presumed to be an employee unless you can use the test to categorize them as a contractor. What’s more, in many states, you have to meet all three prongs of the test before the worker can be treated as a contractor.

The ABC Test Factors

The ABC factors are:

  • Worker is free from the business’s control
  • Work takes place outside the usual course of business and off the business’s premises
  • Worker is customarily in an independent trade, business, occupation, or profession

This test is extremely difficult to meet. For example, if you run a chain of gas stations famous for clean toilets, you might need a plumber to fix some of these toilets on a somewhat regular basis. But the plumber might not pass the second prong of the ABC Test. They have to fix the toilet on the gas station’s premises, and, arguably, having lots of clean and working toilets is a part of the gas station’s business model. Yet it completely makes sense to use local, independent contractor plumbers to do the work.

A Special Note on California’s ABC Test

Sometimes, the ABC Test can get really complicated. One of the most notable examples is California’s ABC Test.

California adopted the ABC Test through a law called AB5. The state did not realize that a lot of contractors like musicians, freelance journalists and writers, and freelance photographers actually really like being independent contractors. Under AB5, many of these creatives would suddenly be classified as employees.

The issue caused so many problems that California modified AB5 with AB2257, which came into effect in September, 2020. Under AB2257, a lot of the traditionally contractor jobs like website designers, musicians, writers, and photographers are excluded from California’s ABC Test. Instead, you use a modified version of the Borello Test (California’s version of the common law test) to decide if the worker is a contractor or an employee. Here is the full list of occupations excluded from California’s ABC Test, along with the specific test you’re supposed to use to analyze the contractor vs. employee question.

Be Sure to Check with Your State’s Rules

At the end of the day, every state will have its own test for deciding between employees and contractors. Most of them will have some tweaks to the Common Law Test or the ABC Test.

For your convenience, here’s a link to the Department of Labor’s helpful information page on which test each state uses for unemployment insurance. Be sure to click on the PDF documents to see the details of each state’s test.

What Happens if You Misclassify Workers?

As you can see from above, the contractor vs. employee determination can get really tricky. Sometimes, businesses make honest mistakes and misclassify their workers.

So, what are the penalties if you misclassify a worker? Typically, you pay several types of fines. Just how much you have to pay depends on the specific law. Here are some typical penalties:

  • A per worker fine
  • Backpay, including an extra percentage based on the wage
  • Back taxes, including interest
  • Payment of benefits
  • Jail time in extreme cases

How to Stay Safe on the Contractor vs. Employee Question

Yes, it can get very unpleasant if you misclassify a worker. But it also doesn’t make sense to hire every worker as an employee. After all, some folks actually want to remain independent contractors.

So, what can you do to avoid trouble, in light of all the complicated classification laws? The safest solution, of course, is to ask for a lawyer’s help. But we realize that this isn’t always practicable for most small businesses.

Instead, here’s what we suggest. Start with a firm idea of what type of work you need to hire a worker to do. Then, think through how much control over the worker you’ll need to make sure the worker does a satisfactory job. Is it possible for you to assign a piece of work, tell the person the type of results you expect them to turn in to you, and set a due date? (For longer projects, you’re allowed to check a few times in the middle of the project to keep them on track.) Is it practical for you to pay the person on a per-project basis instead of hourly basis?

If you think you can do all of the above, then you can probably use a contractor. But this isn’t the end of your inquiry. As a last check, go to your state’s website and look for your state’s contractor vs. employee test, and analyze the job you just scoped out against that test.

Yes, the process will still be somewhat complicated. But at least it’s a logical way to figure out what type of worker you need to hire to get the work done.  

Interested in starting and running a small business? Here’s the beginning of our step-by-step guide: What to do right after getting that great business idea.

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DISCLAIMER: This article does not constitute legal or accounting advice. Instead, it contains general information. The information gives you the background you’ll need to hit the ground running when you do go get advice from a lawyer or accountant. Only lawyers and accountants properly licensed in your state/country are qualified to give you legal or accounting advice.

Questions? Comments?