Should a Small Business Owner Hire an Independent Contractor or Employee?

Small Business: Hire an employee or contractor? Andersen Law PC

When you own growing small business, you’ll likely hit the point where you need to hire help. Then the question becomes whether to hire an independent contractor or an employee.

When deciding between the two options, there are several factors to consider.

Even though Colorado is an employment “at will” state (meaning that either the employer or the employee may terminate the employment arrangement without notice or cause, absent a contract or other binding agreement to the contrary), hiring an employee burdens a small business owner with a greater level of commitment to the individual, more managerial responsibilities, and higher administrative expenses than paying for a contractor’s services. For example, while the legal obligations vary depending on the employee’s status and title, hours worked, and the nature of their work, you will generally have to provide various benefits to the employees hired, such as health insurance, retirement contribution, vacation time, paid time off, workers’ compensation insurance, and unemployment insurance. Further, hiring employees requires you to withhold state and federal taxes, social security, and Medicare from their employee’s paychecks, in addition to keeping detailed payroll records. A small business owner is also obligated to provide employees with proper training and any professional licensing that may be required. 

By contrast, paying for an independent contractor’s services offers several advantages over hiring an employee. Using a contractor provides you with greater flexibility and allows a lower level of commitment to the contractor and their work. For example, if the contractor’s work isn’t satisfactory, you might simply not hire the contractor again, as opposed to reprimanding, suspending, providing additional training and/or supervision, or firing an employee. Further, you aren’t responsible for the contractor’s training, licensing, or state and federal tax obligations and filings.

Although paying for an independent contractor’s services offers advantages over hiring an employee, it also poses concerns. While you don’t have to provide contractors with a salary or employment benefits, contractors typically command higher compensation per job or hour. In addition, small business owners lack the capability to control the contractor’s work, as a contractor usually does not perform services on site or under supervision. Paying for a contractor’s services can also prevent a small business owner from promoting their business’s brand, as the contractor will work under their own name and logo.

Before you choose to pay for an independent contractor’s services, it is crucial that both parties address and outline the circumstances of the agreement and follow its terms closely. Otherwise, you could inadvertently form an employer/employee relationship.

Even if the relationship is characterized as a small business owner/independent contractor on paper, an employer/employee relationship can be created if you have too much control over the contractor’s performance. Specifically, if a small business owner has the power to manage and/or supervise the contractor’s performance, an employer/employee relationship may be created. According to the Internal Revenue Service, “The general rule is that an individual is an 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.”

The Colorado Revised Statutes provide several more in-depth factors to help determine an independent contractor’s employment status that small business owners should consider as well. Importantly, you should establish quality standards without overseeing the contractor’s work, instructing them how it is performed, or dictating the time when the services will be performed (although a completion schedule and mutually agreed upon work hours may be established). Next, you should pay the contractor a contract or fixed rate per services performed as opposed to a salary or hourly rate. A small business owner may only provide the contractor minimal training too, and may not provide the contractor tools beyond basic materials. In addition, you should ensure the contractor’s services are not provided to their business exclusively, although the contractor may provide exclusive services to the business for a finite and defined amount of time. Lastly, a small business owner should make payments to the contractor’s trade or business name as opposed to paying the contractor personally.

Failure to correctly classify an independent contractor can be disastrous. If the I.R.S. determines that an independent contractor is in fact an employee of your small business, and has been incorrectly listed as a contractor, you might be liable for unpaid payroll taxes and penalties, unpaid unemployment insurance and workers’ compensation insurance premiums, administrative claims for withholding regular employee benefits, and may face greater exposure to potential governmental audits and civil suits.

Once you have decided to pay for an independent contractor’s services, you must satisfy two I.R.S. requirements. First, you must have the contractor complete a Form W-9 in order to determine the contractor’s correct name and taxpayer identification number (which is either a social security number or employment identification number). The I.R.S. recommends a small business owner retain this form in their records for four years following the completion of the contractor’s services in case any questions arise.

Next, you must complete a Form 1099-MISC if you have paid the contractor over $600 for services throughout the year. If the contractor is incorporated as a C-Corporation or S-Corporation (including an LLC), a Form 1099-MISC is generally not required unless the incorporated contractor provided legal services. In this case, attorney’s fees must be listed in box 7 of the Form 1099-MISC, and gross proceeds must be listed in box 14. If required, a copy of the Form 1099-MISC must be provided to the contractor no later than Jan. 31 of the year following payment.

James Hanseen and Jacquelyn Gutc contributed to this article.

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