Hiring Employees Vs Contractors For Your Small Business – The Ultimate Small Business Startup Guide Part 5

This is part 5 of a 7 part guide on how to start a small business.

Given enough time and hard work, your business will eventually take off and you’ll find yourself needing additional help in order to expand. If you are looking to hire your own workforce, there are many things you need to consider. For starters, there are 2 basic types of help that you can hire, employees and contractors. And ultimately, the type of workers you choose to hire can have far reaching implications for your small business.

Hiring Help Is Not That Straightforward.

This portion of the guide will help to define the difference between contractors and employees along with the headaches associated with hiring each type. The main thing to keep in mind is that if you don’t do things by the book, you could be in for a world of hurt if the government ever finds out.

The Difference Between Contractors and Employees

The main difference between contractors and employees is that contractors are in business for themselves. Therefore, when you hire a contractor to help you out, you are essentially paying them to perform a specific service for you on their own time using their own resources. They are also responsible for declaring taxes on their own personal income. In short, when hiring a contractor, the paperwork burden is on the contractor and not on your business.

On the other hand if you hire your own employee, you are responsible for taking care of and paying a bunch of taxes. In addition, there’s a ton of paperwork involved that needs to be filed with the government on a regular basis.

Why Don’t I Just Stick With Contractors And Avoid The Hassle?

Does hiring a contractor sound more favorable to you? In almost all cases, it’s much easier to hire a contractor than an employee especially if you are running a small business. But what’s the catch? Why not always hire contractors and avoid all of the paperwork? The catch is that there are many important distinctions and rules that must be followed when classifying a worker as a contractor or employee. If you are ever caught treating a contractor like an employee, you can be punished by the IRS big time.

Just as a side note, hiring a contractor versus an employee is something that my wife and I struggled with for a long time with our online wedding linens business. It can be extremely complicated to hire your first employee, but once you get past all of the red tape with your first employee, the incremental cost of hiring another one is very small.

That being said, if you can find independent contractors to do the work for you, there’s really no reason to hire your own employee. Hiring your own employee usually makes sense if the nature of the work is unique or special to your company. It’s also nice to be able to bring up and train a worker to do things your way using your own methodologies. In the end though, it’s a tradeoff between additional cost and headaches versus control. You have to make the call.

When Is A Worker Considered A Contractor?

You can safely classify a worker you hire as a contractor if…

  • The worker has his/her own tools to do the job
  • The worker has his own office or place of business
  • The worker does work for several other clients as well
  • The workers does the work on his/her own time and sets the hours

When Is A Worker Considered An Employee?

You should classify a worker as an employee if…

  • The worker works for you and only you
  • The worker works a number of hours that you set.
  • The worker uses your equipment to do the job
  • The worker gives orders or supervises any of your employees

What If It’s Ambiguous?

In many cases, a worker you hire might fall somewhere in between a contractor and an employee. Ultimately, you need to make the call but keep in mind that the penalties can be quite stiff if you ever make the wrong distinction.

For example, if you ever need to fire one of your contractors that you’ve been treating as an employee, they could technically demand to be paid unemployment by the government. If the government finds that you erroneously classified your employee as a contractor, then the IRS could force you to pay back any back taxes along with stiff penalties. In general, if you are unsure, you should always classify your workers as employees. In any case, it’s usually best to consult an expert on the matter.

How Do I Hire An Employee?

Unfortunately, it’s a major pain in the butt to hire your first employee. Just as a reference, I’ve outlined all of the major steps involved below. As you will see, there are a lot of things that you will need to do. What I especially hate about the entire process is that you have to file paperwork with several different agencies in addition to the government. Now why the heck would a country that was built upon capitalism and entrepreneurship make it such a hassle is beyond me and probably a good topic for a different post.

Are you ready? Here’s a general idea of what is required to hire your first employee.

  • You must obtain workers compensation insurance and notify the employee of their worker’s compensation rights. Fortunately, worker’s comp insurance isn’t that expensive but can get pricey depending on the nature of your business.
  • Within 20 days of your employee’s first day at work, you must file a report to the Employment Development Department or EDD for short.
  • You must start performing payroll and paying payroll taxes. This includes withholding state and federal income taxes from employee paychecks. You also must report these wages and withholdings to the IRS using a W-2.
  • You have to register and pay for unemployment insurance at the state level. Ever wonder how unemployment benefits are funded? Now you know.
  • You have to withhold employee contributions to your state’s disability program.
  • You must pay unemployment taxes at the federal level as well. This is a tax that you have to pay directly instead of taking it out of your employee’s paycheck.
  • You must pay the employer’s portion of Social Security and Medicare taxes for each employee based on your employee’s wages
  • You have to make sure that your office complies with state and federal safety laws set forth by OSHA. Basically, you have to have an injury prevention plan and more or less keep track of all injuries at the office.

Is It Worth The Hassle?

The bottom line is that hiring your first employee is a huge step and requires a ton of paperwork and regulation. Handling payroll is no easy task either. To make things smoother, I strongly recommend that you contract out your payroll to a 3rd party. They will handle all of the paperwork and necessary filings and all you have to do is tell them who to pay and how much.

In any case, I also recommend trying to stick with contractors for as long as you can. As long as no specialized work needs to be done for your small business, there’s really no pressing need to take on the burden of having an employee. Of course, only you can be the judge. Once you hire your first employee though, it’s a cake walk to add on additional staff.

Next Up: Small Business Accounting, Bookkeeping and Analysis

Ready To Get Serious About Starting An Online Business?


If you are really considering starting your own online business, then you have to check out my free mini course on How To Create A Niche Online Store In 5 Easy Steps.

In this 6 day mini course, I reveal the steps that my wife and I took to earn 100 thousand dollars in the span of just a year. Best of all, it's absolutely free!

Give Me Access To The Free Course!
Enter Your Email Address:

Similar Posts

Have you read these?

10 thoughts on “Hiring Employees Vs Contractors For Your Small Business – The Ultimate Small Business Startup Guide Part 5”

  1. Very good advice!

    I think that there are many companies who use “contractors” and don’t understand this information (even though it’s available on the IRS website).

    I always get a little concerned if a company expects a contractor to work only for them and tries to dictate how and when that work is done.

    There can also be a problem if employees and contractors are doing exactly the same work and fall under the same restrictions. I once worked for a company that was sued for treating employees and contractors alike.

    That being said, I have over dozen different clients and all of them allow me to work independently. If think those companies are pretty safe in saying that I am a contractor.

    1. Hey Laura,
      There is actually a very famous case where a bunch of contractors sued Microsoft for treating them like employees. Microsoft ended up having to pay a lot of penalties and back taxes in addition to benefits. For a small company, these penalties can put you out of business so that’s why I recommend that every business owner err on the side of caution.

  2. The distinctions between what “is” an employee vs. a contractor are incredibly important, and Steve’s comments re: that Microsoft case sprang to mind for me, as well.

    That said: one huge reason most people become entrepreneurs is because they believe themselves smarter than . . . well, certainly smarter than the government! And if you are careful you can craft your policies such that your contractors STAY contractors (this is one of the things we do all the time for our clients, by the way).

    So the whole “who needs the hassle of an employee?” question comes back up as what’s important, and the answer is that you do if you need people available to you in a certain way at a certain time. Other than that . . . you don’t need them.

    Jeff Yablon
    President & CEO
    Virtual VIP Business Coaching, Computer Care, and Virtual Assistant Services

  3. Great post!

    This is a difficult subject for many small business owners. A mistake I’ve seen companies make in my consulting business is to hire two people for very similar jobs, one as an independent contractor and one as an employee. This leads to trouble down the line as mentioned in the post, paying the IRS not only the taxes the company should have paid but also the portion that should have been paid by the employee.

    Always consult with an employment attorney or accountant on this subject when starting out!

  4. ocasiog says:

    What about hiring student interns? For example, during a busy season, etc. They get the entrepreneurial experience of operating a business, while you get the benefit of their labor for free!

  5. The contractors do not seem to know the difference between an employee or an independent contractor. You might already be aware that many contractors here (And some other other states) list their employee’s as independent contractors. Of course, this is to avoid workers compensation liability, among other tax and accounting reasons. Many companies need to be educated on these topics, thank you for writing!

    Linwood Smith
    President
    http://eagleemployerservices.com

Leave a Reply

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>