3 Important Hiring Questions: Independent Contractor Versus Employee 

As your business grows, there may come a point when you need help.

Maybe you want to hire a virtual assistant to help with customer service or social media. Maybe you need a photographer for your Etsy shop, a freelance writer for your blog, or someone to help pack and ship boxes you are sending to Amazon. Before you bring someone on, you need to answer an important question:

Are you hiring an employee or an independent contractor?

This matters because the rules, tax reporting, and payroll responsibilities are very different depending on how the worker is classified. And this is not something you get to decide based on what is most convenient. The IRS looks at the actual working relationship to determine whether someone is an employee or an independent contractor.

In this post, I’ll walk you through the main IRS factors in plain English so you can better understand how to classify workers in your small business. If it turns out your new hire is an employee (a very likely scenario), don't fret, just use Gusto to make payroll as easy as possible.

This post is for informational and educational purposes only and should not be considered legal or tax advice. IRS guidance on this topic can be found here. This post also contains affiliate links.

The IRS Looks at 3 Main Categories

The IRS generally groups the employee-vs-contractor analysis into three areas:

1. Behavioral control
2. Financial control
3. Type of relationship

There is no single magic factor that decides the answer. Instead, the IRS says you need to look at the entire relationship and consider the degree of control and independence involved. 

1) Behavioral Control: Who Decides How the Work Gets Done?

The first question is whether your business controls, or has the right to control, what the worker does and how the worker does it.

A worker is more likely to be an employee if you tell them things like:

• when to work
• where to work
• what tools or equipment to use
• what order to follow
• what methods to use
• who can help with the work
• how the work should be performed day to day

Training matters too. If you train someone to perform the work in a very specific way, that may point toward an employee relationship. Independent contractors are usually hired for their expertise and are expected to use their own methods to get the job done.

Example:

If you hire a freelance Pinterest manager and you only care about the result—such as creating pins, scheduling content, and growing traffic—but you do not set their hours or dictate exactly how they do the work, that leans more toward independent contractor.

On the other hand, if you run an Etsy shop and hire someone to come into your workspace, use your tools, follow your production process, and work the hours you set, that looks much more like an employee relationship.

2) Financial Control: Who Controls the Business Side of the Work?

The second area is financial control. Here, the IRS looks at whether the worker controls the economic side of the job.

Questions to ask include:

• Does the worker use their own tools and supplies?
• Does the worker have unreimbursed expenses?
• Does the worker invoice you?
• Is the worker paid by the project or by the job, rather than a regular wage?
• Can the worker make a profit or suffer a loss?
• Is the worker available to work for other clients?

Independent contractors are often running their own business. They may advertise their services, work for multiple clients, buy their own software or equipment, and take on business risk. That all supports contractor status.

Employees, by contrast, are more likely to be paid regularly, use tools provided by the business, and be reimbursed for job-related expenses.

Example:

A photographer you hire occasionally for product images who uses their own camera gear, sets their own pricing, works for many clients, and sends you an invoice likely looks like an independent contractor.

A person you hire every week to come in, use your equipment, and perform ongoing filming work under your direction may be much more likely to be an employee.

3) Type of Relationship: What Does the Working Relationship Look Like Overall?

The third area is the type of relationship between the business and the worker. The IRS looks at factors such as:

• whether there is a written contract
• whether benefits are provided
• whether the relationship is ongoing or indefinite
• whether the worker performs services that are a key part of the business

Here is an important point: calling someone a contractor in a contract does not automatically make them a contractor. The IRS specifically says the actual facts and circumstances matter more than the label in the agreement.

Benefits such as health insurance, retirement benefits, or paid time off usually point toward employee status. An ongoing, indefinite relationship can also lean toward employee status.

And if the worker is performing a core function of your business, that can also be a clue. For example, if your business sells handmade products and you hire someone to regularly make those products under your direction, that may point toward an employee relationship.

The General Rule

The general rule is this:

A worker is generally an independent contractor if the business has the right to control only the result of the work, but not what will be done and how it will be done.

That one sentence is a helpful gut check, but remember: the IRS still expects you to look at the whole picture.

Common Mistakes Small Business Owners Make

One of the biggest mistakes is assuming that a worker is automatically a contractor because:

• they work part-time
• they work from home
• they agreed to be a contractor
• they send an invoice
• you would prefer not to run payroll

Those facts alone do not settle the issue. What matters is the actual relationship and the degree of control.

Another mistake is waiting until year end to think about classification. Ideally, you should decide this before the person starts work.

What to Do If You Hire an Independent Contractor

If your worker is truly an independent contractor, here are a few smart steps to take:

• Have a written contractor agreement.
• Collect a Form W-9 before paying them.
• Keep invoices and payment records.
• Review whether you need to file Form 1099-NEC at year end for reportable nonemployee compensation.

What to Do If You Hire an Employee

If the worker should be classified as an employee, then you generally need to:

• set them up in payroll
• withhold applicable taxes
• pay the employer share of payroll taxes
• file payroll tax forms
• comply with federal and state payroll rules

This is why many small business owners use a payroll service provider. Payroll has a lot of moving parts, and it is much easier to get right when you use a system designed for it.

If you use a payroll platform such as Gusto (the payroll provider I use), it can help automate pay runs, tax filings, and compliance tasks. Just remember that the software does not make the classification decision for you. You still need to classify the worker correctly first.

Pro Tip: while I love using QBO for bookkeeping, I hate their built in payroll program. You'll thank me later if you choose Gusto, which integrates easily with QBO.

What Happens If You Get It Wrong?

Worker misclassification can be expensive. The IRS says that if a business misclassifies an employee as an independent contractor, the business can be held liable for employment taxes.

And tax issues are only part of the picture. Worker classification can also affect labor law and state law obligations, which may use different standards than the IRS. The U.S. Department of Labor has also noted that other federal, state, and local laws may apply different tests.

Final Takeaway

When you hire help in your business, do not start by asking, “Which option is easier?” Start by asking:

How much control do I have over this worker and how they do the job?

That is the heart of the employee-versus-independent-contractor question.

If you control the details of the work, provide the tools, direct the schedule, and rely on the person as part of your ongoing business operations, you may have an employee.

If the worker is operating independently, using their own methods, taking on business risk, and simply delivering a result for you, they may be an independent contractor.

When in doubt, slow down and review the facts before you pay them. It is much easier to get this right on the front end than to clean up a misclassification problem later.