To Payroll or Not: Hiring Contract vs. Salary Employees

This article is a reprint of Wise Bread's contribution to OPEN Forum from American Express -- where small business owners can get advice from experts and share tips with each other.

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You have some projects coming down the pipe that you need additional staff for. What do you do: offer your potential new team player an independent contract or full-time salary position?

Generally speaking, you will pay more in hourly wages for a contractor than for a salaried employee. However, you will also save gads of money on employee-related expenses that can be burdensome. The long-term cost implications of hiring staff can be onerous if your business can’t absorb them.

Beyond dollars and cents though, are a number of factors that will help you decide whether your next hire should be a contractor or an employee.

I. EMPLOYER VIEW

A. Why Hire Contractors

1. Easy Come Easy Go

If things don’t work out with your new contractor, you don’t have to worry about sticky regulations around firing or laying-off a contractor. Severance packages are a non-issue.

2. Plans Change

If the company changes direction or a project gets canned or changed, there is no employee to fire or unemployment paperwork to contend with.

3. Quick as a Bunny

If you have a new project that needs immediate attention, you stand a better chance of acquiring a contractor faster than an employee.

4. Short-Term Projects

If you only need help for a finite duration, then a contractor may be the best choice.

5. Keep That Small Office Space

Many businesses that employ contractors don’t provide office space for them. If you have a small office to begin with and want to bring in new help, you may not need to expand your space to accommodate contractors.

6. No Health Insurance to Pay For

Because of the high cost of health insurance benefit plans, hiring a contractor – and saving this expense – can amount to big savings. Expect to save from $5,000-$10,000 per contractor per year that would be spent on an employee’s health plan.

7. Trained and Ready to Go

Contractors come ready to do the job with minimal guidance and training. This is part of what you are paying for when you pay contractors higher hourly wages.

B. The Downsides of Hiring Contractors

1. Lack of Control

Independent contractors are just that: independent. They will often expect to make their own hours, and could be juggling other projects simultaneously.

2. Lack of Commitment

Without as much of a vested interest in the company, contractors might appear to be blasé about the business. This can be countered with a profit-sharing mechanism, if the contract is long-term enough for it to be an incentive.

3. Whoops – They’re Not Contract

If you made an error and your contractor really is an employee in the eyes of the law, then you could be on the hook for some of the employee-related expenses you thought you were saving like employment tax, as well as interest and possible penalties to ensure you don’t do it again. Make sure you are on top of the current legislative requirements.

4. Too Many Balls/Contractors in the Air

If you have a bevy of projects and contractors for each one, you might find yourself becoming overwhelmed from juggling too many contractors. This is when deadlines can get missed.

C. Why Hire Salary Employees

1. Long-Term Needs

If your needs are for full-time long-term work, then hiring an employee often makes more sense.

2. Key Management Positions

In order to ensure that the right knowledge base stays with the company after a project ends, you may want to fill key project management positions with employees.

3. Confidentiality

If the information to be dealt with is confidential or sensitive in nature, employers often feel that this information is most secure with employees, not contractors.

4. Loyalty + Promotion = Productivity

If your employees are loyal to you and the company, you will have a team of people working for the betterment of the business. If you have a chance to promote these employees (if not with a raise, then possibly tax-free perks or a shift in role), they may in-kind respond with heightened productivity.

5. Flexibility

Small businesses especially require their staff to work in multi-faceted roles which continue to evolve with the business. This will keep employees motivated and stimulated, whereas contractors might be unwilling to move beyond the scope of their expertise.

D. Downsides of Hiring Salary Employees

1. Extra Expenses

Employee-related expenses include training, health insurance, paid vacation, paid sick-leave, retirement plans, worker’s compensation, payroll taxes, social security taxes, unemployment taxes, and others, depending on your industry and business. Technically these expenses even out the additional money you would pay a contractor in wages, but this is not always so. The long-term costs of having an employee can often be higher than a contractor.

2. Office Space

You have to provide an ergonomic workspace for your employees. Expanding your staff might also entail expanding your office space to accommodate them.

3. Management Blues

You probably started your small business because of your inherent industry-related expertise and skills. But now that your company is growing its employee base, you are forced to be a people manager. Employees, as a general rule, require more hand-holding than contractors.

4. Liability

You open yourself up to employee/work-related lawsuits by having employees on the roster.

II. EMPLOYEE VIEW

No employer’s analysis would be complete without stepping into the shoes of their employees as an acid test. Here are some reasons why your employees might prefer a contract or staff position.

A. Why Choose Contract Positions

1. Hourly Wages

A contractor earning an hourly wage might also be eligible for overtime, paid at time-and-a-half. Salaried employees make a flat wage, regardless of the hours worked.

2. Tax Deductibility

Employees cannot deduct any expenses related to their job, including transportation to and from work. Contractors however, can deduct just about any expense they bear that can be construed as enabling them to do their job, including home office space, auto expenses, insurance, utility bills, computers, and office supplies. Please note though, that a dollar deducted from your income for tax purposes does not equate to a dollar saved in taxes. If this is money the contractor would spend anyway as an employee, then they will see an overall savings.

3. More Money

Typically, independent contractors will make more money than employees in the same position. Even after expenses and taxes, this amount can still be higher, but is entirely dependent on the individual situation.

4. More Control

Contractors ultimately have control over their schedules, working conditions, and projects.

5. Ability to Freelance

Some employer-employee agreements prevent employees from working at other jobs, especially if they are industry-related. In some cases employees are prevented from working for competitive companies even after they have left their current employment. Being a contractor circumvents these issues.

B. Downsides of Being a Contractor

1. Business License Requirements

Depending on the location, industry, and income, contractors are required to have a business license, which can be an additional annual expense.

2. Accounting

Contractors have to be on top of their accounts, including invoicing and receivables, taxes, deductions, and various other detailed matters that require a level of organization that is not always natural or easy.

3. No Extra Perks

Contractors don’t get holiday pay, health coverage, sick pay, retirement plans, annual bonuses, or a host of other employee perks.

4. No Unemployment, No Safety Blanket

If your contract ends unexpectedly, you are not eligible for unemployment benefits since you are considered to be self-employed.

5. Extra Taxes

Contractors must pay the employer portion of all taxes, including federal, state/provincial, and sometimes even municipal taxes.

6. Always On the Hunt

Contractors are always on the hunt for new contracts to either supplement their existing work or to replace expiring contracts. Shaking trees for leads is not everybody’s forte.

7. Higher Cost of Insurance

Employer-sponsored health insurance plans often cost much less (due to the spread of risk across a group) than individual health insurance plans necessary for contractors. There is a loophole though: sometimes contractors who belong to a professional group or association may be eligible for group benefits through them at a discounted rate.

8. Lack of Job Security

This is a big one, and is not to be underestimated. Employees receive regular paychecks, sick leave, vacation benefits, and various fringe perks. All they have to do is show up. For some, this peace of mind is a significant enough benefit to counteract all the potential advantages of choosing a contract position.

III. GUIDELINES FOR HIRING CONTRACTORS

1. Payscale

The general rule of thumb is that a contractor’s wages should be about twice an employee’s salary for it to be worthwhile. While this figure may seem steep, consider that fringe employee benefits cost 20-50% of a salary, in addition to the employer-related taxes and fees you pay on behalf of the employee.

2. Business is Business

The contractor/employer relationship is much more a business relationship than an employee/employer relationship, which has extra scope. For you, this extra scope may be desired, or conversely, avoided at all costs.

Whether your next hire is one of an employee or contractor will depend on where your business is, what your needs are, and what the industry outlook is in your line of work. Some people will prefer taking on contract positions, while others will run screaming from them. However with this framework above as a guide, hopefully your next hiring decision will be smooth and free of unexpected obstacles.

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