When your business needs staff, one of the key decisions facing you is whether to hire an employee or engage with someone as an independent contractor. Independent contractors are more commonplace now than ever before. The number of independent contractors rose by 1 million from 2011 to 2012* and is predicted to rise steadily each year.

Despite its popularity, there are many rules that dictate whether you can legally staff with independent contractors instead of employees.  Understanding the tax and legal requirements before you add staff will help to ensure that you avoid fees and penalties down the road.

Review the following FAQs to learn about this type of staffing.

What is an independent contractor?
An independent contractor is someone who completes a project or other work for your business according to their own ideas and using their own tools and equipment. The Internal Revenue Service (IRS) defines an independent contractor as someone who performs a job without any control on the part of the person paying them over what will be done and how the work will be done. Examples of true independent contractors provided by the IRS include: doctors, dentists, contractors, lawyers, and others performing this sort of very independent work.

What is the difference between an independent contractor and an employee?
The answer to this question has to do with control over the work completed. Common traits of an independent contractor include: having other customers besides your business, having his or her own tools or equipment not paid for by you, operating under a business name, having employees, and advertising his or her services. Employees, on the other hand, usually have one employer who has a say over how the person completes work tasks.

If you are unsure, you also have the option of filling out a form and submitting it to the IRS for them to consider the details of your situation and make a determination. This may sound like a lot of work; however, if you repeatedly use independent contractors in the same role in your business, this effort may be well worth it. Download the form at http://www.irs.gov/pub/irs-pdf/fss8.pdf.

Is an independent contractor easier to hire?
If someone works for you as an independent contractor, you typically only commit to that person for the time it will take to complete a project or task. This arrangement provides more flexibility for your company than hiring an employee because you can easily part ways at the end of a project if you are not pleased with their work and avoid the unpleasantness and effort associated with firing.

Which one will cost my business more?
Independent contractors are responsible for their own expenses and are typically less expensive than employees, “all in.” One of the big reasons for this is that your business does not have to pay for an independent contractor’s social security, Medicare taxes, unemployment insurance, and workers compensation insurance. Your business also does not have to buy the tools and technology that an independent contractor will use to complete the work nor do you have to provide office space for them. Your business will likely pay an independent contractor more per hour, but they will cost you less than an employee when you factor in all of the expenses associated with having an employee.

Is there upside to hiring employees?
Your commitment to someone as an employee with a salary and benefits can pay off when you need commitment back from them. Employees can typically make time for work that comes in or handle quick turnaround projects your business needs. Independent contractors may not be available whenever you need them because they have other customers besides you. An employee who is most familiar with your business and its customers may also do the best job when you need something done. Your control over how a project is completed is potentially much greater with an employee, since independent contractors by definition need to determine how work will be completed. You may also not own the rights to work that an independent contractor creates for you, so speak with your accountant about all of the rules governing your work before you hire an independent contractor.

What happens if I misclassify someone on my taxes?
If your company staffs up with someone in the role of an independent contractor who is really functioning as an employee, you may face financial penalties. These penalties can include having to reimburse them for wages, including overtime; pay benefits such as health insurance after the fact; or pay and file back taxes for the period in which they worked for your business.


Learning to correctly designate staff is an important part of your small business hiring. Doing it right may help you avoid tax mistakes and even penalties. The rules may be modified over time, so keep in close touch with your tax preparer or accountant when you make these decisions to ensure that you are staying within the law.

*MBO Partners


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