When it comes to hiring someone for your startup, you can pursue one of two workforce strategies: hiring an employee or a contractor. Both have their advantages and disadvantages, but your choice depends on what your needs are, what your budget can accommodate and the constraints of relevant labor laws.
This article compares employees and independent contractors and discusses worker classification. Employment law is governed by both state and federal law, so any principles discussed in this article are broad generalizations. Seek counsel to understand what’s right for your specific situation. If you’re looking for counsel, feel free to contact us here.
Employees are long-term team members at a startup who commit to work at a company longer term. This is often considered a deeper commitment to the company’s success. Employees have roles that include broader organizational contributions. Employees are sometimes referred to as W-2s, after the tax form associated with employees.
Pros of Employees:
- Commitment and Loyalty. Employees often exhibit a higher level of commitment and loyalty to the company, as they are more integrated into the business and its culture. They are not short-term, project-based workers. They may have a long-term perspective and be more dedicated to the company’s success. Employees are often granted equity to align long-term incentives.
- Control and Direction. As an employer, you have more control and direction over employees. You can provide specific instructions, set work schedules, and manage their tasks and performance more closely.
- Skill Development and Growth. Employees can be trained to develop specific skills and methodologies that align with the company’s long-term goals. They can contribute to the company’s growth by acquiring knowledge and experience over time and contributing to the company’s institutional knowledge.
- Culture is often key to a startup’s success. It is built over time as employees work closely together and learn to trust each other, creating a psychologically safe environment that expresses the core values of the startup.
Cons of Employees:
- Cost of Compliance. Hiring employees comes with additional costs, such as salaries, benefits, payroll taxes and potential legal obligations, including workers’ compensation, unemployment insurance and compliance with labor laws.
- Administrative Overhead. Having employees requires managing various administrative tasks such as payroll, benefits administration and Human Resources (HR) compliance. This can add administrative complexity and overhead to the business. Taking into account federal, state and local employment compliance can be overwhelming for an early-stage startup.
- Limited Flexibility. Scaling up or downsizing the team is more challenging due to labor regulations and employment contracts.
At a startup, contractors are team members who possess the skills and equipment to complete specific projects without a long-term commitment or attachment. They are sometimes referred to as 1099s because that’s the tax form associated with contractors.
Pros of Contractors:
- Cost Efficiency. Contractors are typically responsible for their own taxes, benefits and overhead expenses. Hiring contractors can be cost-effective because you only pay for their services, not additional benefits and taxes.
- Specialized Skills. Contractors often possess specialized skills and expertise that may not be available within the core team. You can bring in contractors with specific knowledge for short-term projects or to fill skill gaps.
- Contractors provide flexibility in terms of engagement duration and workload. You can scale the use of contractors up or down based on the demands of the business, without long-term commitments. This is particularly helpful for early-stage startups with a limited budget and/or those trying to control their burn rate.
- Reduced Administrative Burden. Contractors are generally responsible for managing their own administrative tasks, such as invoicing and tax compliance. This reduces the administrative burden on the startup.
Cons of Contractors:
- Limited Control. Contractors operate with a higher level of autonomy. This means that startups have less control over their work methods and schedules. Contractors may have other clients or projects simultaneously, which can affect their availability, responsiveness and quality of work.
- No Commitment. Contractors may have less loyalty and commitment to the company since their engagement is typically project-based. There’s no expectation of loyalty or commitment to the long-term success of the company. They are simply there to execute a specific task.
- Intellectual Property Ownership. Contractors may retain ownership of the intellectual property they create unless specific agreements are in place. This can create challenges if startups require full ownership and control over the work produced. Since intellectual property ownership is essential for most startups, it’s important to have a solid independent contractor agreement in place. If you’d like to learn more about drafting an independent contractor agreement, click here.
The specific advantages and disadvantages mentioned here may vary depending on the jurisdiction and the nature of the startup. Consulting with legal and HR professionals is advisable to ensure compliance with relevant laws and to make informed decisions.
Classifying a Worker as an Employee or Contractor
When hiring an employee or a contractor, it’s necessary to work within the constraints of employment law. Applicable laws vary based on jurisdiction. However, here are some common factors that are typically considered when determining worker classification:
- Control. The degree of control or independence the employer has over the worker is a crucial factor. If the employer has the right to control how, when and where the work is performed, and directs the worker’s activities, it suggests an employer-employee relationship. Conversely, if workers have significant autonomy and control over their work, it leans toward a contractor relationship.
- This relates to the level of direction exercised by the employer over the worker’s day-to-day activities. If the employer tells the worker exactly how to do their job, or gives them a process to follow and supervises the worker closely, it implies an employment relationship. On the other hand, if the worker determines their own methods and approaches to complete the work, it suggests a contractor relationship.
- The financial aspects of the working arrangement are also significant. An employee is typically paid a regular wage or salary and may receive benefits such as health insurance, paid leave or retirement contributions. Contractors, however, are often paid an hourly or flat-fee invoice for their services or compensated based on project completion. Contractors generally bear their own expenses and do not receive employee benefits.
- The length of the working relationship can be a factor. Independent contractors are usually engaged for a specific project or a defined period. If the worker has an ongoing, long-term relationship with the employer, it can indicate an employment relationship.
- The extent to which the worker’s services are integrated into the employer’s business is considered. Employees typically perform tasks that are essential to the core operations of the business, while contractors may provide specialized or supplementary services.
- The extent to which a worker is able to work for other companies may be a consideration. Employees are, for the most part, required to exclusively work for the company, whereas contractors often are working on different projects for many companies simultaneously.
The above factors are an over-simplification based on some state and federal laws, but the specifics matter. The factors and the specific weight given to each factor can vary depending on the jurisdiction. Different countries and states may have their own specific tests or criteria for classifying workers, such as the “ABC Test” used in California or the “Control Test” used in the United Kingdom. It is advisable to consult local labor laws or seek legal advice to understand the classification rules applicable in a particular jurisdiction.
All told, if someone is working on a time-bound project of limited scope with a high degree of freedom over how they achieve the objectives, and especially if they are providing similar services to other companies, you may have the legal option to classify them as a contractor versus an employee.
Factors to Consider When Deciding Between Hiring an Employee or a Contractor
If you have the option to hire someone as a contractor, would you take it? Why or why not? This elaborates on the factors you might consider to make a decision.
- One important factor is the level of control needed over the work being done. If you require more control over how the work is completed and when it’s done, hiring an employee may be more appropriate.
- Another factor to consider is the length of the project. If you have a short-term project that requires specialized skills, hiring a contractor on a project-by-project basis may be more cost-effective than hiring a full-time employee.
- Skills. The skills required for the job are also important. If you need someone with specific expertise in a certain area, it may make sense to hire a contractor with those skills rather than investing time and resources into training an employee.
- Lastly, consider your company culture and values. Employees are typically more invested in your company’s mission and goals than contractors. If having someone who shares your company’s vision is important to you, hiring an employee may be the better choice.
By evaluating these factors alongside other specific considerations for your startup situation, you’ll be able to make an informed decision about whether to pursue hiring an employee or contractor that aligns with your business needs and goals.
Penalties for Misclassification
Misclassifying an employee as an independent contractor can have serious implications, depending on the jurisdiction and extent of misclassification. Here are some potential consequences:
- Back Taxes and Penalties. If you fail to withhold income taxes, you might be held responsible for the full amount that should have been withheld plus penalties and interest. You may also owe back taxes for Social Security, Medicare and unemployment insurance.
- Wage and Hour Claims. If independent contractors should have been classified as employees, they may be entitled to minimum wage and overtime under federal and state laws. The company could be liable for any back pay due, plus additional damages.
- Benefits Claims. Misclassified workers may be entitled to employee benefits, including health insurance, retirement contributions, stock options or paid time off. If the worker has paid for these expenses out-of-pocket, the employer may be required to reimburse them.
- Workers’ Compensation and Unemployment Insurance. If independent contractors are injured on the job or dismissed, they may file for workers’ compensation or unemployment benefits. If the worker is reclassified as an employee, the employer may be responsible for these costs.
- Penalties and Fines. Government agencies may assess penalties and fines for misclassification. In some cases, intentional misclassification can lead to criminal charges.
- Legal Fees. If workers challenge their classification in court, the employer may have to pay legal fees to defend against the claim. If the worker prevails, the employer may also be ordered to pay the worker’s legal fees.
These are just a few examples, and the specific consequences can vary based on the jurisdiction, the nature of the misclassification and other factors. It’s always advisable to consult with a legal professional if you have questions about the correct classification of workers. This will help minimize the risk of legal issues and ensure that you are in compliance with all applicable laws.
In recent years, there has been a notable rise in the scrutiny and enforcement efforts by state departments of labor to crack down on worker misclassification. Misclassification is seen as a significant issue that impacts workers’ rights and tax revenues. As a result, many state governments have taken proactive measures to address this issue. Here are some key aspects of the rise in state enforcement:
- Legislative and Regulatory Actions. Several states have passed or updated legislation to strengthen their stance on worker misclassification. These laws often clarify the criteria for determining worker classification, increase penalties for violations and enhance enforcement mechanisms. They may also establish task forces or specialized units within state departments of labor to investigate misclassification cases. For instance, California’s passage of AB-5 makes it very challenging to classify a worker as a contractor.
- Increased Funding and Resources. State departments of labor have received increased funding and resources to enforce worker classification laws. This includes hiring additional staff, auditors, and investigators to identify and address misclassification cases. The additional resources allow for more comprehensive audits, investigations and enforcement actions.
- Enhanced Cooperation and Information Sharing. State labor departments are collaborating more closely with other government agencies, such as tax authorities and workers’ compensation boards, to share information and coordinate enforcement efforts. This cross-agency collaboration enables a more holistic approach to identify misclassification cases and enforce compliance.
- Targeted Audits and Investigations. State labor departments are conducting targeted audits and investigations to identify employers who misclassify workers. They may focus on specific industries or sectors that are known for misclassification practices, such as construction, transportation and the gig economy. These audits can include examining employment records, contracts, financial documents and interviewing workers to determine proper classification.
- Penalties and Fines. State governments are imposing stricter penalties and fines on employers found guilty of worker misclassification. These penalties can include monetary fines, back wages, interest payments and reimbursement of employee benefits. Repeat offenders may face even higher penalties and may be subject to increased scrutiny in the future.
Properly classifying your workers as an employer is crucial to avoid costly penalties and lawsuits, as the U.S. Department of Labor, the Internal Revenue Service and many states are actively enforcing worker classification laws. Startups are particularly at risk for misclassification issues, which can be expensive to resolve, especially if they have multiple workers and the misclassification has been going on for years.
Startup Guidelines for Avoiding Contractor Misclassification
If a startup chooses to hire an independent contractor, it’s essential to take certain precautions to minimize the risk of misclassification. Here are some steps a startup can consider to minimize the risk:
- Get It In Writing. Establish a clear contractual agreement that outlines the relationship as that of an independent contractor. The contract should specify the scope of work, deliverables, payment terms and duration of the engagement. It should also explicitly state that the independent contractor is not an employee and is responsible for their own taxes and benefits.
- Maintain Independence. Avoid exercising excessive control over how the independent contractor performs their work. Provide guidelines and objectives, but refrain from dictating specific processes or work hours. Contractors should have the freedom to choose when, where and how they complete the tasks.
- Avoid Exclusivity. Independent contractors typically work for multiple clients simultaneously. Avoid requiring exclusivity or restricting them from taking on other projects or clients. This helps demonstrate their independence and entrepreneurial nature.
- Require Contractors to Provide their own Devices/Tools. Independent contractors should use their own tools and equipment whenever possible. If the startup provides any tools or equipment, ensure that it is for convenience and not a requirement for the contractor to perform the work.
- Avoid Benefits. Independent contractors should not receive benefits typically associated with employees, such as health care, vacation time or retirement plans. These benefits blur the distinction between contractor and employee.
- Maintain a Separate Business Identity. Encourage independent contractors to operate as separate businesses, having their own business name, website, email address and business cards. They should also have their own liability insurance, if applicable.
- Avoid Supervisory Relationships. Limit direct supervision and control over the independent contractor’s work. Allow them to complete the tasks independently, without constant monitoring or performance evaluations.
- Clearly Distinguish Roles. Make sure the contractor’s role is different from that of employees. Independent contractors should not be performing the same work as employees on an ongoing basis.
- Seek Advice. If you have concerns or uncertainties about properly classifying a worker, it’s advisable to consult a Human Resources professional or an employment attorney who is knowledgeable about labor laws in your jurisdiction. They can review your specific situation and provide guidance tailored to your startup’s needs.
In conclusion, when deciding whether to hire an employee or a contractor for your startup, there are several factors to consider. You should evaluate the level of control needed, the length of the project, the skills required, and your company culture and values. Properly classifying your workers is crucial to avoid costly penalties and lawsuits. Remember, the classification of independent contractors versus employees can be complex, and is subject to specific laws and regulations in different jurisdictions. It’s important to consult with Human Resources or an employment lawyer to ensure compliance with applicable laws and regulations.