Payroll vs. Contractors

W-2, or full/part-time employees are the jobs most people are familiar with. “W-2” refers to the tax form an employee gets during tax season that states their earnings and tax withholdings throughout the year. These workers have consistent jobs and 40 hour work weeks, and will generally only work for the company they are employed at. As an employer, hiring W-2 employees comes with a certain amount of responsibilities, including tax withholding and employee benefits. For this reason, it’s generally recommended to try and utilize independent contractors to scale your business in the beginning before jumping into launching payroll for a bunch of employees. 

An independent contractor is exactly what it sounds like, an independent third party. They are responsible for paying their own self-employment tax, and are not subject to any tax withholding or benefits from the company. Contractors will typically receive a 1099-MISC tax form at the end of the year, simply stating how much money the contractor was paid by the company. Independent contractors are typically freelancers (can be other small businesses as well) that specialize in a specific trade, and don’t put in enough hours working for your company to qualify as a full time employee. An example of a contractor could be photographers, artists, designers, lawyers, editors, consultants, or anyone else working for a specific purpose for a specified period of time, usually for a finite project. Independent contractors typically have other clients in their given field, and won’t be expected to give your company 100% of their time and effort. Any of these positions could also be full time employees if you needed them to start putting in 40 hour work weeks for your company specifically. 

Independent contractors are frankly way easier to deal with in the beginning than employees, but it’s important not to misclassify workers as contractors if they’re actually behaving as employees. The IRS is fairly strict on this with consequences for misclassification of workers, including penalties like back paying employment taxes if a stated contractor is deemed to really have been acting as an employee. According to the IRS:

“Facts that provide evidence of the degree of control and independence fall into three categories:

Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?

Financial: Are the business aspects of the worker’s job controlled by the payer? (these include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)

Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?

The keys are to look at the entire relationship and consider the extent of the right to direct and control the worker. Finally, document each of the factors used in coming up with the determination.”

Note: see hyper-links for specific IRS guidance on “Behavioral”, “Financial”, and “Type of Relationship” qualifications. 

One main distinction between an independent contractor and a full-time employee is the amount of time a person is working for your company. If a “contractor” is regularly pulling 40 hour weeks for your business and doesn’t have any other clients, it’s going to be difficult to continue justifying their independent contractor status.