Employee vs. contractor: how a simple misclassification can cost you thousands
Employee vs. Contractor: What Every Small Business Must Know Before Hiring
One of the biggest decisions a small business makes when bringing on help is whether to classify someone as an employee or an independent contractor. While the difference may seem simple, the IRS — and state agencies — have very specific rules. Misclassification can lead to costly penalties, back taxes, unpaid benefits, and even legal disputes.
This guide breaks down the difference in clear terms so business owners can hire confidently and stay compliant.
Why Classification Matters
Classifying someone correctly affects:
How you pay them
Whether you withhold taxes
Your obligation to provide benefits
Your workers’ compensation requirements
Your overall payroll costs
Your legal and financial liability
A simple mistake can end up costing thousands — but proper classification can protect your business while giving you the flexibility you need.
What Defines an Employee?
An individual is considered an employee when the business controls:
1. How the work is done
You set their schedule, methods, tools, and daily tasks.
2. The financial relationship
You pay wages consistently (hourly, salary), reimburse expenses, and provide equipment.
3. The working relationship
They’re expected to work long-term, follow company policies, and represent your business.
Employees typically receive:
W-2 at year-end
Payroll tax withholding
Workers’ compensation
Possible benefits (PTO, health insurance, etc.)
Employees are integrated into your business — not operating independently.
What Defines an Independent Contractor?
Contractors operate as separate businesses who control how the work is done, even if you're the one who hires them.
Contractors typically:
Decide when and how they work
Use their own tools, software, or equipment
Work for multiple clients
Invoice for services
Take on profit or loss risk
Contractors receive:
A 1099 at year-end (if paid $600+)
No tax withholding from your business
No benefits, no unemployment, no workers’ compensation (unless your state requires coverage)
They deliver a service — not ongoing labor.
The IRS “Common Law Test”
The IRS evaluates classification based on three categories:
1. Behavioral Control
Do you control how the work is performed?
2. Financial Control
Do you control how the worker is paid or whether they can earn profit/loss?
3. Type of Relationship
Do you expect a long-term relationship, or is it project-based?
If the answer leans toward “you control,” the worker is likely an employee.
Real-World Examples
Scenario 1: The Bookkeeper
A business hires Susan to handle monthly bookkeeping. She works from home, charges a flat monthly fee, uses her own software, and has five other clients.
➡️ She is a contractor.
Scenario 2: The Receptionist
John works in the office Monday–Friday, follows your schedule, uses your computer, and handles daily office tasks.
➡️ He is an employee.
Scenario 3: The Website Designer
A business hires a designer for a one-time website overhaul. The designer chooses the timeline, tools, and methods and invoices upon completion.
➡️ Contractor.
Scenario 4: The Delivery Driver
A bakery hires a driver to deliver orders daily, using the bakery’s vehicle and route schedule. Even if paid per delivery, because the bakery controls the process,
➡️ They are an employee.
What Happens If You Misclassify a Worker?
Penalties can include:
Back taxes for Social Security, Medicare, and income tax
Overtime and back wages
Interest and penalties for late payroll taxes
Possible legal consequences under wage and labor laws
The IRS, state labor departments, and state tax agencies all have authority to audit.
How Small Businesses Can Protect Themselves
✔ Create written contracts for all contractor relationshipsClearly state the scope, independence, and payment structure.
✔ Avoid treating contractors like employeesDon’t set strict schedules, provide equipment, or require them to attend staff meetings.
✔ Keep detailed recordsDocumentation is your best defense in an audit.
✔ Reevaluate roles annuallyA contractor today may evolve into an employee role over time.
✔ Consult your accountantA tax professional can identify red flags before they become liabilities.
The Bottom Line
Classifying workers correctly isn't just a legal obligation — it's a financial safeguard. With the right understanding and structure, businesses can confidently hire the help they need without exposing themselves to costly penalties.
