A single word cost FedEx $100 million. That word? "Contractor."

In 2016, the shipping giant settled a long-running lawsuit over whether its drivers were contractors or employees. This costly error isn't unique to big corporations. Small businesses and individual workers face the same risk every day, often without realizing it.

The line between contractor and employee isn't just legal jargon—it's a critical distinction that can make or break your financial future. From tech startups to local shops, misclassification has sparked lawsuits, bankruptcies, and major policy debates.

In this blog, we'll explore the key differences between these two worker types. We'll provide clear guidelines to help you determine whether you're hiring a contractor or an employee and discuss the important implications for both employers and workers.

Who is a Contractor?

Contractor or contract labor refers to employees who provide services to your business under specific terms, typically for a defined period or project. You pay them as per a pre-decided rate.

Here's what it means for your business:

1. The worker isn't on your regular payroll. You don't give them a salary or hourly wage like you would an employee.
2. You don't take taxes out of their pay. The worker handles their own taxes.
3. You don't provide benefits like health insurance or paid time off.
4. The worker usually uses their own tools and decides how to do the job.
5. Often, the work is for a specific project or time period, not ongoing.

From a legal compliance standpoint, the classification of workers is governed by strict IRS and Department of Labor guidelines. The IRS uses a 20-factor test to determine worker status, which falls into three main categories:

1. Behavioral Control: The degree of instruction and training provided.
2. Financial Control: The worker's investment in equipment, unreimbursed expenses, and opportunity for profit or loss.
3. Relationship of the Parties: Written contracts, employee-type benefits, permanency of the relationship.

Contractors must receive Form 1099-NEC for non-employee compensation of $600 or more annually. This form must be provided to the contractor by January 31 and filed with the IRS by February 28 (paper filing) or March 31 (electronic filing).

Businesses should maintain detailed records of contracts, payments, and the nature of work performed. The Safe Harbor provision (Section 530 of the Revenue Act of 1978) may provide some protection if you've consistently treated workers as contractors and have a reasonable basis for doing so.

Why you should hire contractors?

Flexible Workload

Most startups don't have enough steady work to keep full-time employees busy year-round. Imagine you're running a small marketing agency. You might land a big project that needs a graphic designer for a month, but then have nothing for the next two months. Hiring a contractor for just that one project makes more sense than paying someone full-time when there's not always work to do. This flexibility is crucial for new businesses with unpredictable workloads.

Cost Savings

Money is typically tight for new businesses, and hiring contractors can help save cash. When you hire an employee, you're not just paying their salary. You're also covering things like health insurance, paid time off, office space, and taxes. With a contractor, you just pay for the work they do. No extra costs. This can be a big deal when every dollar counts. For example, a tech startup might need a specialized software developer for a specific feature. Hiring this expert as a contractor for a few weeks is much more cost-effective than bringing on a full-time developer with a hefty salary and benefits package.

Specialized Skills

Hiring contractors lets startups and agencies tap into a wide range of specialized skills without committing to full-time hires. Maybe you need a web developer for one project, a copywriter for another, and a social media expert for a third. Instead of trying to find one person who can do all these things (which would be tough and expensive), you can hire specialists for each job. This way, you get top-notch work without having to keep these experts on your payroll full-time.

Quick Scaling

Contractors allow businesses to scale up quickly for big projects or busy seasons without the long-term commitment. For example, a small e-commerce startup might bring in additional customer service contractors during the holiday rush, then scale back down in slower months.

Who is an employee?

An employee is an individual hired by a company or organization to perform specific duties in exchange for regular compensation. Here are the key characteristics that define an employee:

• Employees receive a salary or hourly wage on a consistent schedule, typically weekly or bi-weekly.
• The employer withholds income taxes, Social Security, and Medicare contributions from the employee's paycheck.
• Employees are often eligible for company benefits such as health insurance, retirement plans, paid time off, and unemployment insurance.
• The employer has the right to control what work is done and how it's performed. This includes setting work hours, providing necessary tools and equipment, and directing the work process.
• Employers typically provide job-specific training to employees.
• The employment relationship is usually ongoing and indefinite, rather than for a specific project or time period.
• An employee's work is generally essential to the core business operations of the company.
• Employees usually work for one employer at a time and may have restrictions on working for competitors.

Employees have certain legal rights and protections that contractors don't. This includes things like minimum wage laws, overtime pay for hourly workers, and protection against discrimination. Make sure you're familiar with employment laws in your area when hiring employees.

Misclassification of workers as contractors or employees

While the difference between employees and contractors might seem like mere paperwork to some founders, it's actually a crucial distinction with significant legal and financial implications. It's not just about what feels right or what's most convenient for your business at the moment.

Many business owners fall into the trap of thinking, "As long as the work gets done, does it really matter how I classify my workers?" The short answer is: yes, it absolutely does.

Misclassifying your workers – treating employees as contractors or vice versa – isn't just a minor administrative error. It's a serious issue that can lead to hefty fines, legal troubles, and damage to your business reputation. Employees get benefits, minimum wage, overtime pay, and job protections that contractors don't. When a worker is misclassified, they might miss out on these important perks. For the business, misclassification can mean unpaid taxes and big fines if they're caught.

Common scenarios when missclassification happens:

• Long-term "temporary" workers: Workers hired for a short-term project but kept on indefinitely, often without changing their status to employees.
• Part-time workers are treated like full-time employees: Part-time contractors are given the same responsibilities, oversight, and integration into the company as full-time employees.
• Remote workers with set schedules: Contractors who work from home but are required to follow strict company schedules and procedures, similar to regular employees.
• Workers doing core business tasks: Contractors hired to perform essential, ongoing work that is central to the company's main business operations.

How to prevent misclassification?

Preventing worker misclassification is crucial for any business. Here are four key strategies to help you avoid this common pitfall:

Understand the Legal Criteria

Familiarize yourself with the IRS and Department of Labor guidelines for classifying workers. These typically focus on three main areas: behavioral control (does the company control or have the right to control what the worker does and how?), financial control (are the business aspects of the worker's job controlled by the payer?), and the type of relationship (are there written contracts, employee benefits, etc.?). Knowing these criteria is your first line of defense against misclassification.

Conduct Regular Audits

Don't set and forget your worker classifications. Regularly review the status of your workers, especially if their roles or responsibilities have changed over time. What started as a contractual relationship might have evolved into an employment relationship without you realizing it. Annual audits can help catch these shifts before they become problems.

Use Clear, Written Agreements

For every worker, whether employee or contractor, have a clear, written agreement that outlines the nature of the relationship. This should include details about the work to be performed, payment terms, and the level of control the company will have over the work. While a written agreement isn't foolproof, it can provide important documentation of the intended relationship.

Be Consistent in Your Treatment

If you have multiple workers performing similar roles, be consistent in how you classify them. Treating similar positions differently can raise red flags. If you do have a mix of employees and contractors doing similar work, make sure you can clearly articulate and document the reasons for the different classifications.

Hire Fast and Easily With Thera

All this talk about employee classification and compliance can make your head spin. It's a lot to keep track of, especially when you're just trying to run your business and get things done.

That's where Thera comes in. We're not here to give you another headache - we're here to take one away.

Here's the deal: Thera is an all-in-one platform that helps you manage your whole team, whether they're employees or contractors, working from down the street or across the globe. We handle the tricky stuff like payroll, compliance, and even those pesky AP/AR processes.

What does that mean for you?

• No more wondering if you've classified your workers correctly
• No more juggling multiple systems for payroll and payments
• No more sleepless nights worrying about compliance issues

We've got your back, whether you're paying someone in pesos, pounds, or yen (and yeah, we handle over 150 currencies).

If you're curious about how we could help your business, schedule a demo with Thera and see if we're a good fit for what you need.

‍