Contractor or Employee? What’s the Difference?

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There was a close call in Washington D.C. this year. Within the vast health care reform bill that the Obama Administration crafted, there was a law that required all businesses to complete a 1099 form for every business transaction made with outside businesses. In the past it was only for transactions above $600 so the removal of this $600 limit would have produced a paperwork nightmare for businesses and for small businesses with limited staff, it could have been detrimental to their growth.

That law was recently repealed and the $600 limit reinstated. This is great news for all business owners large and small. If you’re starting a business or you’re an established business owner, it’s important to remember that although that $600 limit is again in place, you have to designate your employees correctly or the IRS could impose penalties. Although you like the idea of saving the time of handling payroll taxes, insurance, and the other paperwork headaches that come with having actual employees, you can’t call them contractors unless they truly are independent. Here are a few guidelines from the IRS to remember when making this designation.

Behavioral Relationship

If the person in question works exclusively for you at or around 40 hours a week and you have control over what the worker does and how they perform their job, you probably have an employee. A contractor would generally have other clients and be more task oriented than hours oriented unless their contracted work could only be completed in a certain time frame. If they have office space where they reside each day, they’re probably an employee instead of a contractor.

Financial Relationship

If you tell them when and how they will get paid, it’s likely that they are an employee especially if that payment comes at regular intervals in the form of a paycheck instead of a payment as a result of a submitted invoice. If you give the person in question access to health care benefits, 401(k), sick days or other company benefits, they are most likely an employee. A contractor would be paid as a vendor and have very little access to company perks since they are, in theory, independent.


If the person in question performs duties that are essential to the day to day operation of your business, they are most likely an employee. If you hire somebody to answer your phones, handle payroll and accounts payable, or drive a daily delivery truck, the IRS will most likely consider that person to be an employee.

Bottom Line

There’s no denying the fact that an employee costs more than a contractor but the IRS knows that and they’re always on the lookout for business owners who are trying to get around those requirements. If you are at the beginning stages of forming a business, consider very carefully the duties you require of your potential employee and fashion those needs around the designation you want. If you don’t want to pay the taxes associated with an employee, give them duties consistent with a contractor.