Whether you go for a full-time or part-time employee or settle on a 1099 contractor will be determined less by the type of small business structure you choose than where you are in scaling your business.
By Team Roll on May 23, 2022
7 min readWe know behind every successful business is an amazing support team. Whether you go for a full-time or part-time employee or settle on a 1099 contractor will be determined less by the type of small business structure you choose than where you are in scaling your business.
So which is better when you consider contractors vs. employees? Contractors and employees both offer unique benefits for small business owners. It's important to understand when to use each option, especially when you're just starting your own business.
The IRS lists five types of business structures any sized business can take:
The structure you choose will affect the amount of taxes you will pay, your ability to raise money, the paperwork to be filed, and your personal liability. You must choose your structure before you register your business with your state. Depending upon your company type (and sometimes state), you may also need to obtain a tax ID number as well as file for any applicable licenses and permits.
When your business is financially feasible and there is enough additional work to warrant taking on help, that's the time to add employees and/or contractors.
If you're a solopreneur or have staff, regardless of your business structure, you'll know it's time to take on help when you must decline work because you (and your people) are overwhelmed or overworked, your revenue starts to stagnate, and/or your customer service begins to suffer.
Making the choice between hiring an employee or contracting an independent contractor depends upon where you are in the scale of your business, how much work you have to dole out, and whether the type of work you need to be done is an integral part of your business. Learning the difference between an employee and an independent contractor can help you in your decision-making process.
At least three federal government agencies have a test to define a 1099-NEC independent contractor, sometimes referred to as 1099s. (Some states refine the definitions even further.) Each agency has its own angle, so each test has a slightly different focus. That said, many test factors coincide, while others contradict each other.
To determine whether a worker can be classified as an independent contractor, you cannot use just one test — you must use them all. Just making a good faith effort to clear as many factors as possible will set you on a course to the correct classification.
The three tests come from the Department of Labor, the IRS, and the National Labor Relations Board (NLRB).
FLSA Test. The most familiar test is the one from the Department of Labor (DoL), known as the FLSA Test because it refers to the Fair Labor Standards Act. While the U.S. Supreme Court has repeatedly held there is no single rule or test for determining whether someone is a 1099 or an employee (also called a W-2) for purposes of the DoL, it does say the total activity or situation controls.
The factors the court wants business owners to look at are:
The Court considers immaterial:
Though there is not one single determinative factor, control is key. The DoL is going to look at whether the individual:
If an individual must be available to work 30, 50, 70, or more hours a week for one company, that makes it impossible to work for anyone else, let alone competitors. That looks like an employee. Other factors that make an individual look like an employee include whether the person:
So, the DoL is looking at control factors. The more control you exert over someone's work, the greater the chance the DoL is going to say you have an employee.
IRS Test. While the DoL focuses on the total activities and situation of individuals to make its determination of 1099 vs. W-2, the IRS is concerned about its tax base. As an employer, you must withhold income taxes, pay Social Security, Medicare taxes, and unemployment taxes on all wages paid to employees. None of that happens with independent contractors. (Independent contractors must pay their own taxes.)
To satisfy the IRS, you must keep two key points in mind when classifying employees:
If you still cannot determine if an individual is an employee or an independent contractor, use IRS Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding (PDF).
NLRB Test. Since many small business owners do not have unionized employees, they aren't as familiar with this test. Whether or not your employees are unionized, however, these factors still apply.
There are 11 factors the NLRB looks at to determine status:
No one factor is decisive. You have to visualize a scale with this test. On one side, there's the independent contractor plate. On the other, the employee plate. You're never going to get every factor on one plate. Some are going to go on each plate. In the end, whichever side drops is the determinative side, and that's where the NLRB will go with its findings.
Each test is equally important. You must consider all three.
With the federal government's focus on making it difficult to be classified as an independent contractor, there are going to be more challenges. If you haven't already audited your positions and contracts, now's the time to start. You need to show a good-faith effort.
So, which type of worker should you choose for your type of business? Employees are better for your business when you must have a position covered at all times. Independent contractors are better for your business when you need intermittent (by project) work done. Just make sure that when you classify someone as an independent contractor, you weigh the position to be filled against each test and check with your state department of labor for local rules. Getting it wrong can be costly. The prudent move would be to have an employment attorney double-check any position you create.
If you want to read further on this topic, you can find more related articles on our blog.