Contractors vs. Employees: Benefits and Drawbacks

Business.com / Human Resources / Last Modified: February 22, 2017

What's the difference between an employee and a contractor, and what are the benefits and drawbacks of each?

A contractor is a self-employed person or an employee of another company (such as a temp agency) that performs similar job functions as a regular employee. Unlike regular employees, the hiring business does not directly pay the contractors' benefits or employment taxes. Independent contractors usually do not have to be carried on a company's workers compensation policy, nor does the hiring business withhold contractor income taxes.

It is also easier to dismiss a contractor than an employee. Most independent contractor agreements specify employment at will, which means contractors can let go without legal implications. Typically, your business is not liable for injuries a contractor may cause while working for you.

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The Benefits of Using Independent Contractors

The chief reasons to hire contractors instead of employees are:

1. Your business has short-term staffing needs.

2. Your business requires specialized skills for a limited time period.

3. To save the expense of recruiting, hiring and training new employees (as much as $4,000 per employee according to one estimate). With a sluggish economy where a downturn might necessitate laying employees off, you might want to hire temps or independent contractors instead.

4. To lessen the expense of employee turnover (on average between 10 to 30 percent of the employee's salary according to one study). Independent contractors and temps allow your businesses to try out people before committing to hire them.

The Difference Between an Independent Contractor and an Employee

The U.S. Internal Revenue Service has pretty clear rules on when someone must be classified as an employee rather than an independent contractor. Some of the indicators used:

  • Does the person work on company premises? If so, it is much harder to classify them as an independent contractor.
  • Is the person paid by their time, such as an hourly wage or weekly salary? Independent contractors are typically paid by their output, not their time.
  • Is the person in control of their own schedule for completing work? If the schedule is dictated by the hiring business, the person is more likely to be classified an employee.
  • Is the person using their own tools? If the tools the job requires are provided by the hiring business, the contractor is more likely to be classified an employee.

The dividing line between an employee and an independent contractor is not completely clear. You can follow all these rules, but there are still circumstances where people you hired as contractors will later be determined to be employees. Here's an example from Microsoft:

Vizcaino v. Microsoft was an action brought by a group of freelance workers who worked there for at least two years, reported to the same supervisors as employees and essentially performed the same work as employees, and were paid directly by Microsoft. Even though they signed agreements saying they were independent contractors, the court ruled that they were, for all intents and purposes, treated as regular employees, and thus entitled to employee stock options that back in the 1990s were quite lucrative.

Consequently, when businesses hire contractors for on-site work, they often go through a temp agency or other employment firm so the contractors are clearly employees of another organization and can not simultaneously be the business' employees.

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The IRS isn't the only government agency interested in the dividing line between independent contractors and employees. Any business involved in interstate commerce comes under the Fair Labor Standards Act. The Affordable Care Act also imposes responsibilities on employers with more than 50 employees. Defining an "employee" rel="no-follow" is critical to determining a company's level of responsibility for health insurance.

To maintain the contractor's status as a "temporary worker," contracts are often of limited duration, usually no more than two years and as short as three months. If you want to use a contractor for longer, you often have to wait a grace period (typically 90 days) before you can rehire them. There are also limits on the number of times you can renew a contractor to perform the same job function and keep them classified as temporary.

Some Drawbacks to Using Independent Contractors

The disadvantages of independent contractors are:

1. It's difficult to foster team and company loyalty. Again because of the need to draw a firm line between the classifications of employee and contractor, contractors are not invited to outside company functions such as motivational seminars, team-building exercises, celebratory events, and even developmental training. This kind of separate-but-equal treatment can easily make contractors view their work as just a job, and not worth expending any extra effort beyond the minimum required.

2. It's a two-way street. Just as you can terminate any contractor at will, contractors are free to move on to the next job with little or no notice. While it's true your own employees could do this, too, because there are time restrictions on the terms of a contractor's job, he or she is much more motivated to be on the lookout for the next job opportunity elsewhere. Critical job functions may be impaired if a certain percentage of your work force is prone to high turnover and lack of commitment.

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