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Updated Nov 20, 2023

Contract Workers vs. Employees: What Your Business Needs to Know

Employees are loyal team members whose work and hours you can control, but contractors are a whole different story. Learn why you might need both – and how to classify them.

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Jennifer Post, Business Operations Insider and Senior Writer
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This guide was reviewed by a Business News Daily editor to ensure it provides comprehensive and accurate information to aid your buying decision.

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Hiring a contract worker rather than a full-time employee could save your business money; after all, you won’t have to pay for a contractor’s health insurance, 401(k) match, vacation time or other benefits. However, choosing this option also comes with limitations and potential risks. Before you decide which type of worker to use for a given role, it’s critical to understand the differences between contractors and employees and the consequences of misclassifying workers.

Editor’s note: Looking for an employee monitoring solution for your business? Fill out the questionnaire below to have our vendor partners contact you about your needs.

>> Read next: The Definition of Independent Contractor Is About To Change

What is a contractor?

A contractor – also called a contract worker, independent contractor or freelancer – is a self-employed person who operates independently on a contract basis. A contractor is not an employee; instead, they run their own entity (such as a sole proprietorship, limited liability company or limited liability partnership) and are contracted by organizations to work on particular projects or assignments. Their contract relationships can be short- or long term. A contractor can work for a company and is paid for their services but is not technically on the organization’s payroll. They can also do work for multiple companies at one time.

Key TakeawayKey takeaway
A contractor is a self-employed worker who operates on a contract basis for clients.

Contract worker versus employee

There are many differences between contractors and employees. Here are some factors to look at when distinguishing between the two.

Payment, taxation and benefits

One of the biggest differences between contractors and employees is the way they are paid and taxed. An employee is on a business’s payroll, so the company pays the employee their hourly wage or salary and withholds the appropriate taxes (e.g., federal income tax, Social Security tax, Medicare tax). An employer often pays for employee benefits as well. These can include mandatory employment benefits, like health insurance, and other desirable perks, like flexible spending accounts (FSAs), health reimbursement arrangements (HRAs), health savings accounts (HSAs); paid vacation; commuter benefits; and stock options. [See our picks for the best HR software and top payroll services to help you track employee benefits, taxes and payroll.]

In contrast, that same organization would pay a contractor an agreed-upon wage for their services but would not withhold or pay any taxes. A contractor is responsible for paying their own taxes, including federal income tax and self-employment tax. Additionally, the contractor must obtain and pay for any benefits they want, including health insurance, independently.

Autonomy

Another major difference between a contractor and an employee relates to their level of independence.

“Most people think the only difference between an independent contractor and an employee is how they are paid,” Michael C. Harman, attorney at Harman Law, told Business News Daily. “In addition to compensation, independent contractors have more autonomy in their work.”

Harman noted that employees are hired to perform specific work at the employer’s direction. On the other hand, independent contractors are typically given a job or project to work on without the company controlling when and how they do it, he said.

Onboarding and training

The onboarding and training processes also differ greatly between contractors and employees. Because contractors are expected to focus on a specific project, they are often given only the information that’s critical for completing that particular task, said Kimberly Schneiderman, senior marketing manager at The Josh Bersin Company. But full-time employees require a lengthy onboarding process to understand the intricacies of team dynamics, the company culture and the organization’s overall objectives.

Hiring goals

Schneiderman said the hiring goals for employees and contractors are also different.

“While companies work to ensure full-time employees are engaged and work to gain loyalty, these same organizations need to realize that their contractors are always looking for the next gig and are not invested in long-term outcomes, as full-time employees are expected to be,” she said.

Instead of focusing on long-term loyalty, as they would for someone with employee status, many businesses prioritize a contractor’s niche expertise. Many companies seek particular knowledge or skill sets for specific projects or assignments, even if that means using contractors for the short term.

Flexibility

Yet another difference between an employee and a contractor is the degree of flexibility they have in their work. An employee works for one company and is therefore subject to the rules and obligations set forth by that company. A contractor, by contrast, has the choice to work for one or multiple organizations; in fact, it is common for contract workers to juggle several clients at one time. They decide how much time to devote to each company they’re contracted with.

This level of flexibility can be seen as a benefit or a limitation, depending on the type of work-life balance the person seeks. For example, contractors can take time off whenever they feel like it, but they do so at the cost of not making money during that time. Employees, however, are usually granted paid time off.

TipTip
Independent contractors who work from home may be able to deduct associated expenses on their tax returns. Learn more in our guide to small business taxes.

How to distinguish an independent contractor from an employee

The Internal Revenue Service (IRS) looks at certain factors to see if a worker should be classified as an independent contractor or an employee of a company. Attorney Christy L. Foley said these questions can help you determine how to classify a worker.

  • When, where and how is the work done? Is the work performed at the employer’s place of business, or does the independent contractor work remotely? Does the employer set the hours, or can the independent contractor work whenever they want? Does the employer provide the tools, or does the independent contractor use their own equipment?
  • Is the worker required to complete company training? Independent contractors usually do not have this requirement.
  • Is the worker doing full-time, ongoing/continual work? Or are they doing temporary work on projects that have specific endpoints?
  • Is the worker paid hourly, weekly or monthly? Or do they get paid once an entire project is complete?
  • Does the company pay for travel? For employees, travel costs are usually covered by the company. Independent contractors, however, pay their own travel expenses (and usually earn enough on the overall project that those costs end up being covered by the fee they’re paid).

“Technically, the IRS has about 20 factors that it looks at in determining whether someone’s an employee or an independent contractor,” Foley said. “However, the ones listed above are the most commonly used.”

Did You Know?Did you know
Gig work can sometimes blur the line between employees and contract workers, depending on the specifics of the job.

The below table summarizes the key differences between employees and contract workers.

 

Employees

Contract workers

Payment

In regular installments

Upon project completion

Taxation

Withheld from paychecks

Not withheld from paychecks

Benefits

Administered and paid for by employer

Self-administered and self-paid

Autonomy

Must work according to employer’s discretion

Can work entirely on their own terms

Onboarding and training

Full-scale, months-long process

Receive only instructions and information necessary for each project

Hiring goals

Continuous, long-term engagement and loyalty

Niche expertise or skills for individual projects

Flexibility

Must follow employer rules and obligations, including work to be done, location and hours

Full flexibility over projects to accept and work location, quantity and hours

Work travel

Covered by employer

Paid out of pocket

What happens if a worker is misclassified?

The consequences for misclassification – i.e., wrongly classifying an employee as a contractor – vary depending on whether the misclassification is deemed intentional.

“Typically, a company will [be] required to pay back taxes, as well as fines and penalties that can be based on the number of IRS Form W-2s that the company failed to file because of the misclassification and a percentage of wages in which the company failed to withhold the proper taxes,” Harman said.

In extreme cases, he said, businesses could face criminal penalties, and a worker who has been misclassified could be entitled to overtime pay for time worked in excess of 40 hours per week, as well as additional monies, such as punitive or liquidated damages if the worker is successful in a lawsuit against the company.

Foley added that besides monetary consequences, there can also be disputes over who owns the work that was created.

“The business typically owns employees’ work,” Foley said. “Independent contractors’ work must be signed to the company in a separate contract.”

Key TakeawayKey takeaway
Worker misclassification can have monetary and legal repercussions.

To contract or not to contract

It’s simple to determine whether someone working for you should be classified as an employee or a contractor, and you can easily change their status too. Namely, you can offer contractors part-time or full-time employment if your continuing relationship proves especially beneficial. Similarly, if employees leave your company on good terms, you can continue your relationship with them through contract work. It all comes down to what you need and when you need it – as well as what the employee or contractor needs.

Max Freedman and Skye Schooley contributed to this article. Source interviews were conducted for a previous version of this article. 

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Jennifer Post, Business Operations Insider and Senior Writer
Jennifer Post has spent nearly 10 years advising small business owners on best practices for human resources, marketing, funding and more. She devotes her time to ensuring entrepreneurs are equipped with not only the knowledge necessary to launch and grow a successful business but also the software products and tools that are essential for everyday operations. These range from CRM and credit card processing solutions to legal services and email marketing platforms. Post, who has a bachelor's degree in journalism, has shared her expertise through Fundera, The Motley Fool, HowStuffWorks and more. Most recently, she has focused on risk management and insurance, two key areas business owners must understand to sustain their enterprises.
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