Contract Labor: A Guide For Employers

signing a contract

How you manage your human resources can make or break your small business. Interviewing, hiring, and onboarding employees can be an arduous task, especially if your company has yet to build out an HR department.

That’s why more and more small business owners are relying on contract labor to cut back on operational costs and simplify their legal responsibilities. It should come as no surprise, then, that nearly 33 percent of all jobs added between 2010 and 2014 were freelancers or independent contractors.

Evidence suggests that we’re quickly becoming a nation of contractors. In 2018, 36 percent of the US workforce (or roughly 57 million people) earned an income as a freelancer. As the gig economy grows, we can expect this figure to continue soaring.

If you’re wondering how you can capitalize on this growing trend in the market, read on. We’ll cover everything an employer needs to know about using contract labor and how it can pad your bottom line.   

Contract Labor 101

An independent contractor is an individual or business who performs labor or provides goods per a verbal or written contract. Any company in the United States that pays $600 or more for contract labor from an individual contractor must report the transactions to the Internal Revenue Service (IRS) using Form 1099-MISC.

Since income earned by contractors must be reported to the IRS using Form 1099, an independent contractor is often called a “1099 employee.”

Independent contractors are distinct from regular full and part-time employees for several reasons. Below, we’ve listed a few of the key distinctions that set 1099 workers apart from full-time employees:

  • Contractors submit invoices for billable hours or projects
  • Contractors control the number of hours worked
  • Contractors can use their equipment
  • Contractors aren’t paid benefits or workers’ compensation
  • Contractors can be dismissed at any time (contract permitting)
  • Contractors require an agreement before work is performed

If you’re considering hiring an independent contractor for your small business, first consult an attorney about drafting a contract. Don’t be fooled by online template contracts—a contract that is suitable for one contractor (e.g., an IT specialist) isn’t likely to be suitable for another (a mechanic).

Ensure that your contracts include basic provisions to cover all legal liabilities you might incur. For instance, a credible contract will include terms such as conflicts of interest, intellectual property agreement, injury liability clauses, early termination clauses, the maximum permissible number of hours worked, and a breach of contract or nullification clause.

You’re Still On The Hook

Hiring an independent contractor doesn’t mean you can skirt around the IRS—in fact, quite the opposite. Federal and state tax laws hold that every contractor must have a defined position within your organization, and they must be traceable by IRS officials.

Use the US Bureau of Labor employee classification system to organize your workforce personnel and report each of them annually with your company’s tax return. Otherwise, you may receive an unwanted visit by the IRS.

1099 vs. W2: Which Is Better For Your Business?

We’re often asked, “what is a 1099 employee?” However, we’re not often asked about their counterpart—the W2 employee. Unlike 1099s, which refer to contract work, a W2 employee is a salaried or wage-earning employee who is not their own business owner. In other words, W2 employees are included and taxed on your company’s payroll.

When it comes to 1099 vs W2 employees, both are named after the respective forms that they owe the IRS. As opposed to 1099s, employers file Form W-2 rather than their employees. This creates a little more work for employers during tax season, but often private accountants handle these clerical tasks.

There are crucial differences between 1099 and W2 workers, and it’s essential to understand them so you do not confuse the two. If the IRS or Department of Labor (DOL) audit your tax returns, your company may be on the hook for severe fines and penalties in the form of back taxes. If the DOL finds that you’ve misclassified your workers, you may be liable for up to three years of back pay.

The Difference Between 1099 and W2

You cannot determine whether a 1099 worker or W2 employee is better for your business without first understanding what sets them apart. Currently, the IRS has three criteria that they use to determine whether a worker should be classified as 1099 or W2:

  • Behavioral Relationship: Does the contractor have control over their hours worked, location of work, and how they perform the work?
  • Financial Relationship: Does the contractor or contractee control the method of payment, such as a salary or day rate?
  • Contractual Relationship: Does the contract include a provision of benefits, and what other terms are laid out in the contract or agreement?

A 1099 contractor enjoys a significant degree of control over their work. That is the primary difference between 1099 and W2 employees. If a contractee dictates how, when, and where a 1099 contractor performs the work outlined in the contract, then the IRS will likely consider this a misclassification, which may result in costly penalties.

Hiring independent contractors is not appropriate or feasible in some scenarios. For instance, if you run a retail store and need additional workers during the busy holiday shopping season, you would hire W2 employees rather than 1099 workers. This is because 1099 contractors cannot be told where and when to work as a regular shift worker would.

The Benefits Of Choosing 1099 Contractors

In many cases, contract labor is beneficial for small businesses and large enterprises alike. Independent contractors add value to companies by providing much-needed flexibility and cost savings. Below, we’ve listed some of the main benefits of choosing 1099 contractors.

Cost Savings

There are more companies looking for contract labor than ever before. The surge in demand for contractors is because they’re significantly cheaper to hire than conventional employees.

In 2010, the US Bureau of Labor Statistics reported that less than 70 percent of employer costs for employees are dedicated to wages. The other 30 percent of costs go toward benefits and legal entitlements for W2 employees, such as Social Security, workers’ compensation, Medicare, overtime, shift differentials, supplemental pay, and even bonuses.

Since independent contractors don’t require benefits, the top 30 percent of employer costs are reduced to zero. In other words, hiring an independent contractor would cost (in theory) almost one-third less than it would cost to hire an employee. 

Greater Flexibility

Employers have little flexibility when it comes to W2 employees. In the case of W2 employees, once they are hired, they remain on your payroll until they are fired or laid off. By contrast, 1099 contractors are independent and can remain with the company only as the terms of the contract dictate.

If you need a worker to help your business complete one or two short-term projects, it won’t make sense to hire a W2 employee just to lay them off immediately after. Instead, short and medium-term hires should be brought on as 1099 contractors whenever possible.

Reduced Legal Liability

Although we’re not lawyers, the consensus regarding 1099 contractors is that they are less of a legal risk for your business than a W2 employee would be. Unlike a W2 hire, 1099 contractors cannot file for wrongful termination and are ineligible for workers’ compensation. Consequently, your company doesn’t need to waste money and resources on legal fees.

Greater Specialization

One of the less widely appreciated benefits of 1099 contractors is that they are often specialists in their field. Hiring a 1099 contractor lets you bring in an expert in a niche industry or skill, who can take a leading role on a project to help you innovate or realize long-term benefits for the company (without having to remain on payroll).

What To Do When Hiring An 1099 Contractor

The golden rule when it comes to hiring a 1099 contractor is to define their position. This way, you can prevent a costly misclassification error.

Take, for example, the case of a Project Manager who has recently been hired to handle your firm’s operations on a multi-year project. The verbal or written contract does not feature a defined expiry date, and there is an underlying assumption that the relationship will continue indefinitely. In this case, your firm has full control over compensation and bonuses and reimburses all expenses by the new hire.

In the above case, the hire should be considered a W2 employee rather than a contractor. Due to the level of control that the firm maintains over the worker and the benefits provided by the employer, they should not be given a 1099-MISC tax form. Rather, their status as an employee should be reported using Form W-2.

Bringing an independent contractor onto your team can be hugely advantageous for your business. However, this is true only when done right. Otherwise, you may find yourself in hot water with the IRS and owing fines and back pay due to worker misclassification. That’s why it’s always best to consult a qualified legal professional when drawing a contract for a 1099 independent contractor.

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