As startups map out their growth and hiring plans, it’s not abnormal to prioritize a mix of full-time employees and independent contractors for various reasons; perhaps they don’t yet have the funds to commit to growing their team, or have a limited amount of work for a person with a particular skill set. 


In any case, there are important distinctions between independent contractors and employees that impact various operational and financial aspects of a startup. In this article, we’ll explore the differences between independent contractors vs employees, the advantages and disadvantages of each, and how to manage contractors vs employees to remain within compliance of employment laws.


Learn how Zeni helps startups manage every aspect of their business finances, including tasks related to employee payroll administration.


What’s the difference between an independent contractor and an employee?


The biggest differences between independent contractors and employees is how they’re managed, taxed, and compensated. The below chart provides a direct comparison of independent contractors vs employees:


Independent Contractor

Employee

Definition

An Independent Contractor is defined as: “An individual is an independent contractor if the payer has the right to control or direct only the result of the work, and not what will be done and how it will be done.” (IRS)

An Employee is defined as: “Anyone who performs services for you is your employee if you can control what will be done and how it will be done.” (IRS) 

Advantages

  • Access specialized expertise for a short-term project (e.g. a website redesign or product launch)
  • More flexibility to scale work to meet demands of business
  • Typically less expensive than full-time employee
  • Control over work results, plus how, where, and when work is performed
  • More invested in the success of your business 
  • More predictable costs
  • Longer return on investment, bringing important skills in-house 

Disadvantages

  • Control over work results only
  • No direct control over subcontractors used for your projects
  • No long-term investment in the skills and success of your business
  • Less predictable costs
  • More expensive than independent contractors
  • Less flexibility to scale work to meet demands of business 
  • Upfront investment in time and money across hiring, onboarding, and training processes

Costs to Business

  • Hourly rate or project fee, as agreed upon upfront between independent contractor and business
  • Independent contractors are subject to Self-Employment Taxes
  • Salary, including bonuses, stock and/or equity
  • Taxes, including payroll taxes, income tax withholding, Social Security and Medicare taxes, and Federal Unemployment Tax 
  • Insurance, including Disability and Unemployment Insurance
  • Benefits, including Health Insurance, 401(k), Pension Plan, and other workplace perks 
  • Paid Time Off (PTO), including family leave, sick pay, vacation pay, and more
  • Training and Professional Development 

See also: Startup Bookkeeping: Common Mistakes VC-Backed Startups Make and How We're Solving Them 


Important Differences: Independent Contractor vs Employees 

There might be some project circumstances when hiring independent contractors are a smarter alternative to hiring permanent employees. When your company has a limited term project, like a new product launch or website redesign, hiring an independent contractor might fit the bill.

 

Do you need a specialized proficiency that’s beyond your primary company’s work model? If so, temporarily hiring an independent contractor might be your best move. These professionals have specialized expertise that guarantees that you don’t have to directly supervise them at every step of the process.

 

Think about using a permanent employee if the job is central or ongoing to your business’s main purpose. There are advantages to having a team in place that you won’t have to bring up to date before every new project. Using this kind of permanent workforce could be more cost- and time-effective in the future.

 

Still not sure about the difference between an independent contractor and employees?  Here is a deeper dive into the more important employment considerations you should consider when picking your workforce.

 

Skill Set & Training

Independent contractors are usually independent contributors who bring their specialized level of expertise to a client’s specific task or project, as compared to permanent employees who may work collaboratively across teams and projects within the organization. As a result, employers don’t need to train them like they would with their regular workforce.

 

Independent contractors with a high level of specialization and experience exist in virtually all sectors of today’s economy, making them attractive short-term hires when they can offer specialized skills required for specific projects within an organization. 

 

Control Of Working Conditions

When, where, and how work is completed may differ between a contractor vs employee. Your company culture, in addition to the U.S. Internal Revenue Service (IRS) laws, govern the level of control companies have over independent contractors and regular employees.

 

For independent contractors, employers are primarily focused on the timeline, budget, and contents of the final product or deliverables. And those are more or less the only aspects of an independent contractor’s work an employer can control, per IRS laws.

 

For employees, employers can expect greater control over working conditions, for example where the work is done (in-office or remote), how the work is completed (which devices or resources are used, which individuals within the organization are working on the project, etc.), and more.

 

Contracts & Scopes of Work

Unlike regular employees whose job description might include a general list of tasks and duties, an independent contractor is only responsible for completing the job that’s outlined in the contract or Scope of Work (SOW).

 

A thorough SOW builds a foundation for a positive working relationship, highlighting the hopes and expectations for both parties. Meet with your potential contractors before work begins. Negotiate all pre-approved schedules and payment methods to avoid misunderstandings further down the road.

 

Employee Taxes

Independent contractor taxes are also handled differently than regular employees. When companies hire an independent contractor, that company will pay the contractor in full per the terms of their contract—no need to withhold Medicare, Social Security tax or other federal withholdings like they would for a regular employee. 

 

Independent contractors need to satisfy their tax requirements themselves, and do so by paying what’s called a self-employment tax. The self-employment tax rate is roughly around 15 percent, to reflect the contractor’s expected Social Security and Medicare costs. Self-employment taxes can be tricky, and most independent contractors work with an experienced accountant or CPA to help them plan for and manage their self-employment taxes. 

 

An independent contractor sends in their taxes using their own federal form called the Form W-9. Companies that hire independent contractors submit their own 1099 MISC tax form that correlates with the contractor’s filing.

 

See also: Startup Taxes: A Complete Guide to Filing Small Business Tax Returns 

 

Payment For Work/Service Performed

A permanent employee’s paycheck is based on either (a) a set hourly wage and total number of hours worked, or (b) a set annual salary, paid in regular intervals throughout the year regardless of time spent on the job or level of productivity. 

 

An independent contractor will typically work on a set project fee or an hourly bill rate, and submit invoices to the employer for work completed. Project fees, bill rates, and/or payment terms should be addressed and determined during the preliminary contract/SOW negotiations.

 

How To Determine Worker Classification: Independent Contractor vs Employee

Its important to evaluate each employer-employee relationship for federal employment tax purposes, to ensure your employee classifications are within compliance.


Minimize The Risk Of Employee Misclassification With The IRS' 3-Question Test

The IRS has three common law rules that a business owner can follow when determining if workers are independent contractors or employees, as part of the Fair Labor Standards Act. The IRS will review your company’s profile to determine the worker’s level of independence and control.


These rules fall into the following categories:

1. Behavioral Control: What degree of control does the business owner have over their workers and how these workers do their job? 

2. Financial Control: Does the worker receive a guaranteed salary or wage? Does the business owner have ultimate responsibility for any profits or losses at the company where the worker is placed?

3. Type of Relationship: Does the worker perform tasks that are a core part of the company’s existence? Does the business owner directly pay for employee costs such as worker’s compensation insurance or retirement?


“If, after reviewing the three categories of evidence, it is still unclear whether a worker is an employee or an independent contractor, Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding PDF can be filed with the IRS. The form may be filed by either the business or the worker. The IRS will review the facts and circumstances and officially determine the worker’s status.” (IRS.gov)


What happens if I misclassify an employee or independent contractor?

There are penalties for misclassifying independent contractors, and the severity of the penalties depend on whether the classification was intentional or unintentional.


Companies that misclassify an employee as an independent contractor and have no reasonable basis for doing so may have to pay back taxes and other fines and, in the worst cases, may face criminal penalties.


Independent Contractor vs Employee: What’s The Best Choice For Your Startup?

If you have a limited-time project that’s currently outside of your core business services, considering an independent contractor may be your best route. Talk to your accountant or finance firm to get their input on the benefits of an independent contractor vs employees.

Looking for an accountant with startup expertise to help with financial management, day-to-day management of your bookkeeping, accounting, AP/AR and payroll administration functions (plus more)? Zeni is a full-service, AI-powered finance firm that manages the bookkeeping, accounting, tax, and CFO service needs of more than 100 startups remotely. Our team of finance experts—including tax accountants, CPAs, financial controllers, and CFOs—have over 100 years of combined experience and can help with all levels of tasks from day-to-day bookkeeping to financial planning to advising on financial strategy.

To see how Zeni can help you navigate the financial complexities of your startup, click here to book a demo.