Imagine for a moment you’re the founder of an early stage technology company.
You’re shouldered with a steadily growing workload and set of responsibilities and split your time between dozens of daily tasks.
On top of talking with investors, managing your small team, and marketing your product, you’re now about to embark on a major product development push.
You need help.
However, like many company founders and small business owners, you’re faced with the decision of whether to hire an independent contractor or an employee. You understand that a contractor is different from an employee, but you’re not exactly sure how they’re different, or why you would hire one versus the other.
Perhaps you’re actually in this same situation, and you’re asking questions like:
- What are the tax and labor laws governing an independent contractor vs employee?
- How much control do I have over a contractor vs. an employee?
- What are the costs involved in hiring a contractor vs. an employee?
- Is it easier to terminate the relationship with an independent contractor vs. an employee?
In addition to answering these questions, this article will help business owners and entrepreneurs understand:
- Legislation governing contractor vs. employee
- Key differences between independent contractor vs employee
- Benefits of hiring a contractor vs. employee
Note: If you decide to hire an employee, make sure you read my complete guide for hiring your first employee after you’re done here!
Why Is It Important To Differentiate Between An Independent Contractor vs. Employee?
An independent contractor and an employee are fundamentally different types of a worker in the eyes of Canadian and US labor laws, income tax laws, and workers’ compensation regulations.
The reason for this is that independent contractors are, by definition, employers themselves. Tax agencies in both Canada and the US — the Canada Revenue Agency (CRA) and the Internal Revenue Service (IRS), respectively — refer to independent contractors as “self-employed” individuals.
Both Canada and the United States make clear distinctions in the working status between a self-employed contractor and an employee, particularly as they relate to the following:
|Employment insurance (EI) benefits||State unemployment insurance (UI) benefits|
|Canada Pension Plan (CPP) benefits||US Social Security benefits|
|Workers’ compensation coverage||Workers’ compensation coverage|
|Personal income tax and self-employment tax regulations for Canada||Personal income tax and self-employment tax regulations for the United States|
What Are The Responsibilities Of A Company Toward An Employee vs. Contractor?
Companies employing an employee are responsible for all of the items listed in the previous section. For example, they need to ensure the correct tax withholdings and deductions (e.g. EI, CPP, FICA, Medicare) are made when the employee gets paid.
A company will not do this for a self-employed contractor. It’s the contractor’s responsibility to pay the appropriate taxes and ensure they have appropriate medical and workers’ compensation coverage.
Similarly, employment and labor laws, such as Canada Federal Labour Standards and the US Fair Labor Standards Act, do not apply to independent contractors, but they do apply to employees. These laws govern everything from hiring and termination practices to working hours and vacations.
A summary of these employment laws can be found here.
How Can Professionals Like Lawyers And Accountants Help?
In a recent article “What to Do When Hiring Your First Employee” I suggested that founders and small business owners make sure they have access to a good lawyer and accountant.
Unless you enjoy reading labour codes and employment regulations in your spare time (I mean, who wouldn’t?), I strongly suggest finding professionals who can help you in dealing with more complex issues.
They can assist you in interpreting employment laws and CRA and IRS tax regulations; help you understand their implications and how they apply to you; and provide insight into common law practices that might affect you.
What Are The Key Differences Between A Contractor vs. Employee?
In order to understand the benefits and disadvantages of hiring an independent contractor vs. an employee, we should first understand how they are different in the eyes of the law.
Understanding the differences is important regardless of whether you already have contractors working for you, or are considering hiring your first contractor. Misclassifying a worker and the type of relationship can cost you significant time and money.
Organizations like the CRA in Canada, and the IRS and U.S. Department of Labor in the United States, set out a number of “tests” or “checks” around worker classification, to help determine whether someone is a contractor or employee. Some of these tests include:
1. Level Of Control Or Independence
Control can include behavioral control (level of instruction, training, and guidance given by you to the worker) and financial control (significant investment by you in their work, providing laptops and equipment, business expense reimbursement, etc.).
2. Economic And Financial Risk
If the worker faces financial risk by taking on work, bears all responsibility for profit or loss, and accounts for all costs incurred in the pursuit of that profit, then they are probably an independent contractor.
3. Nature Of The Relationship
How do you and the worker interact with each other? Is there a clear written agreement in place that defines the relationship? Jason Golbey at Golbey Law comments, “It’s critical to put in place a written contract or employment agreement outlining the relationship, and then actually do what the contract says.”
What Are The Benefits Of Contractors Vs. Employees (And Vice Versa)?
At this point, you can probably start to see the pros and cons of a contractor vs. employee, and why you might hire one over the other. There are always exceptions to the rule, but below is a list of some of the typical advantages and disadvantages of each.
Employees Have A Long-Term Commitment To The Company
Independent contractors will also often work with more than one client at a time and set their own priorities on which clients to focus on. On the other hand, contractors also bear financial risk, which may motivate them to deliver high-quality results.
Contractors Can Focus On Short, Well-Defined Projects
The work you need to be done may only require a short time and have a very defined beginning and end. It doesn’t make sense to take on the financial and time burdens of hiring and then firing an employee unless you anticipate having multiple similar projects with work that will go on indefinitely.
Contractor Relationships May Be Easier To Terminate
It may be easier to fire a contractor vs terminating someone’s employment if things aren’t working out. However, this relies on having specific clauses written into the agreement that simplifies termination.
Employee Responsibilities Can Adapt Quickly To Change
It is easier to quickly change the scope of an employee’s role, or their goals and objectives than it is with a contractor. This gives the business owner flexibility to rapidly adapt to changing project priorities, or unforeseen events such as a managing a crisis.
Contractors May Cost More (Or Less) Than An Employee
Because of the temporary nature of their work, the higher degree of specialization, and the experience that they bring, contractors are typically paid much higher hourly rates than employees doing similar work.
On the other hand, by hiring a contractor you avoid paying for employee-related costs such as health insurance, employee benefits, and office supplies and equipment.
The hourly rates and the length of time the person is working will impact the total overall cost. In many cases the overall cost of an employee can be significantly higher than a contractor.
Contractors Can Save (Or Cost) You Time Vs. An Employee
A contractor can save you time that you would ordinarily spend on getting an employee onto the payroll, setting up their workspace, etc. Also, because you don’t have behavioral control over how they are doing work, there is less time required to manage them.
On the other hand, when you invest time into getting an independent contractor up to speed on a project, that time investment is lost if you end up having to hire subsequent contractors to complete or correct previous work.
Contractors Often Require Less Training
An independent contractor requires less training, since they rely on their own experience and expertise to do the work, and have control over how work will be done.
Employees Can Be Easier To Control
You may simply want to have a higher degree of control over how work gets done, in which case it makes more sense to hire an employee vs. a contractor.
Summary Of Contractor vs. Employee Pros And Cons
The following table summarizes the pros and cons of an independent contractor vs. employee, with an ‘X’ indicating an advantage of one over the other.
What Do You Think?
Have you had challenges with correctly classifying a contractor vs. an employee? Do you work with contractors and/or employees in your business, and if so, how do you decide which type to hire? What additional pros and cons have we missed that other business owners and entrepreneurs should consider?
Discuss your ideas in the People Managing People community forum (join the waitlist here!) or share your thoughts in the comments below.
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