Employees vs. Contractors: Payroll and Tax Implications

When you're ready to bring someone on to help with your business, one of the first decisions you'll face is whether to hire them as an employee or engage them as an independent contractor. The choice has significant payroll, tax, and legal implications.

When you hire an employee, you're responsible for:

• Employer payroll taxes: 7.65% of wages (Social Security + Medicare)
• Federal unemployment tax (FUTA): 6% on first $7,000 of wages
• State unemployment tax (SUTA): Varies by state
• Workers' compensation insurance
• Potentially: health insurance, retirement plan contributions, paid leave

On top of the employee's wage, plan to budget an additional 20–30% for employer costs.

With a contractor, you pay their rate and that's it. No payroll taxes, no benefits, no workers' comp. You issue a 1099-NEC if you pay them $2,000 or more in a year.

The IRS and Department of Labor use behavioral control, financial control, and the nature of the relationship to determine worker classification. Key questions:

• Do you control how and when the work is done? (Employee indicator)
• Does the worker set their own hours and use their own tools? (Contractor indicator)
• Is the relationship ongoing and indefinite? (Employee indicator)
• Does the worker work for multiple clients? (Contractor indicator)

Misclassifying an employee as a contractor exposes you to:

• Back payroll taxes (both employer and employee portions)
• Penalties and interest
• State penalties
• Potential lawsuits from workers

The IRS has been increasingly aggressive about worker misclassification, particularly in industries like construction, healthcare, and gig economy businesses.

Hire an employee when:

• You need someone working regular hours under your direction
• The work is core to your business
• You want long-term stability

Engage a contractor when:

• You need specialized skills for a specific project
• The work is temporary or project-based
• The worker has their own business and multiple clients

For more on the bookkeeping and tax implications from the contractor's perspective, see our bookkeeping guide for independent contractors.

• Bookkeeping for Contractors: A Guide for 1099 Workers
• 7 Payroll Mistakes Small Businesses Make
• Small Business Payroll Basics
• Payroll Tax Deadlines Every Small Business Owner Must Know
• Our Payroll Services
• Contact Us

Need help with payroll setup or worker classification? The Gap ProAdvisors handles payroll processing and compliance for small businesses. Contact us or see our payroll pricing.