At some point a growing business needs more hands. The first big decision is how to bring someone on: as an employee on your payroll, or as an independent contractor you pay by invoice. The choice isn’t yours to make freely — the law decides based on the nature of the work — and getting it wrong is one of the costliest mistakes a small business can make. Here’s how to tell the difference and what each path requires.
Employee vs Contractor: The Real Difference
The dividing line is control. An employee works under your direction — you set their hours, methods, and tasks, and the work is part of your core business. An independent contractor runs their own business, controls how they do the work, often serves multiple clients, and uses their own tools. The IRS weighs behavioral control, financial control, and the relationship between the parties. You can’t simply call someone a contractor to avoid payroll — if they function like an employee, the law treats them as one.
What Each One Costs and Requires
- Independent contractor (1099) — you pay an agreed rate, they handle their own taxes, and you issue a Form 1099-NEC if you pay them $600 or more in a year. No payroll taxes, no benefits, no withholding. Simpler and cheaper — but only legitimate if the relationship genuinely fits
- Employee (W-2) — you withhold income tax, pay the employer half of Social Security and Medicare, pay federal and state unemployment tax, carry workers’ compensation, and issue a W-2. More cost and paperwork, but more control over the work
Steps to Hire Your First Employee
- Get an EIN — you need a federal Employer Identification Number to run payroll
- Register with your state — for state withholding and unemployment insurance
- Set up payroll — a payroll service handles withholding, filings, and pay runs; doing it by hand is error-prone
- Collect the paperwork — Form W-4 for withholding and Form I-9 to verify work eligibility
- Get workers’ compensation — required in most states as soon as you have employees
- Understand labor rules — minimum wage, overtime, and posting requirements apply
The Cost of Getting It Wrong
Misclassifying an employee as a contractor to save on payroll taxes can lead to back taxes, penalties, interest, and liability for unpaid benefits if the IRS or your state reclassifies the worker. When a role looks like an employee — set hours, ongoing work central to your business, your tools and direction — treat it as one. If a worker is genuinely independent, a clear written contract and a 1099 are appropriate.
Worker Classification: Getting It Right
Whether someone is an employee or an independent contractor isn’t your choice to make freely — it’s determined by the nature of the working relationship, and getting it wrong is costly. Misclassifying an employee as a contractor can mean back taxes, penalties, and owed benefits.
- Behavioral control — do you direct how, when, and where the work is done? More control points toward employee.
- Financial control — does the worker have their own tools, set their own rates, and work for others? That points toward contractor.
- Relationship — is the work ongoing and central to your business, with benefits attached? That points toward employee.
- State tests can be stricter — some states use an “ABC test” that treats most workers as employees unless you can prove all three of its conditions.
When you’re unsure, lean toward employee or get professional advice — the penalties for misclassification fall on the business, not the worker.
Frequently Asked Questions
What tax forms go with each type of worker?
Employees get a W-2 and have taxes withheld from each paycheck; you pay employer payroll taxes on them. Contractors fill out a W-9 and receive a 1099-NEC if you pay them above the reporting threshold — they handle their own taxes.
What is the ABC test?
A stricter standard some states use to classify workers. A worker is a contractor only if (A) they’re free from your control, (B) the work is outside your usual business, and (C) they run an independent trade. Fail any one and they’re an employee.
Can I switch a contractor to an employee later?
Yes, and sometimes you should — if the relationship has grown to look like employment, reclassifying going forward is the safer move. Document the change and start proper withholding and payroll.
The Bottom Line
Whether you hire an employee or a contractor depends on how much control the work requires — not on which is cheaper. Contractors are simpler and lower-cost but only when the relationship truly fits; employees cost more and carry payroll obligations but give you direction over the work. Get an EIN, set up payroll properly, and classify carefully — misclassification is expensive. When the line is blurry, ask a CPA or employment attorney before you bring someone on.
Further Reading
This article is educational only and is not legal, tax, or financial advice. Business, tax, and lending rules vary by state and situation and change over time. Consult a qualified attorney, CPA, or financial professional before making decisions about your specific business.