Should I Hire Employees or Stick with Contractors?

Q. Dear Mr. Alter,

Thanks for providing this valuable service of answering questions from small business owners.

I have a business partner who insists that we should never hire employees and should always just hire independent contractors. That way, we don’t have to pay employer payroll taxes or offer benefits.

I told him that it’s not that easy. You cannot just call every worker a contractor. My understanding is that the government will give us stiff penalties if we don’t correctly classify our workers.

Also, he says we don’t even have to generate 1099s for contractors unless we are paying them more than $20,000 per year. I don’t think that is right.

Please give us your opinion on this. Thanks!

A. Dear Jaclyn,

You are a very wise woman! In recent years, there has been a trend toward hiring independent contractors rather than W-2 employees. However, many small business owners don’t realize that there are limitations on classifying workers as independent contractors. There is also an IRS threshold for issuing 1099s at the end of the year.

Let’s start with the limitations on employee classifications. Employee classification is governed by the IRS because it is primarily a tax-related concern. At the heart of IRS regulations is the issue of control. If the employer exerts control over when, where, and how the worker does the work, then he/she is classified as an employee rather than an independent contractor.

In order for the worker to qualify as an independent contractor, he/she must meet the following conditions:

• The worker has the freedom to hire and pay his/her own assistants and subcontractors.
• The worker is free to work when and for whom he/she chooses.
• The worker does the work or works out of his/her own workplace.
• The worker is paid on a per-project basis or receives a straight commission.
• The worker runs the risk of profit or loss.
• The worker works for more than one business at the same time.
• The worker makes his/her services available to the general public.
• The worker cannot be fired unless he/she fails to meet the contract specifications.

The vast majority of small business workers do not qualify as independent contractors, although some businesses may be able to rely more on independent contractors than others. If you decide to use independent contractors, it is incumbent upon you — the business owner — to make sure they legally qualify as independent contractors and not W-2 employees. The fines for the misclassification of employees can be stiff. Intentional misclassification can lead to a penalty equal to 100% of the amount of taxes owed.

You can also tell your partner that his 1099 threshold numbers were a little high. Business owners are required to generate annual 1099s for independent contractors they paid more than $600 or entered into a contract for more than $600.

Apart from the legal considerations, there is another reason to classify legitimate employees as W-2 wage earners — employee morale. Yes, you’ll save a few dollars by classifying employees as independent contractors. But the money you save will be nothing compared to the amount you sacrifice by refusing to recognize your workers as valued, full-time employees. Employees are much more willing to commit to employers who are committed to them.

My advice: Tell your partner to bite the bullet and classify your workers as W-2 employees.