Employee vs Contractor: What Every Small Business Owner Needs to Know

Building your team starts with understanding how to classify your workers. Small business owners may think they can save time and money by classifying their workers as independent contractors, rather than employees. But this poses legal, financial, and ethical concerns that can hinder the success of the business. Let's take a look at the key differences between employees and contractors, review the latest Department of Labor rules, and help you make the right choice for you business.

What's the Difference Between an Employee and Independent Contractor?

In the world of small business, it's not uncommon to encounter an employer who believes they can hire employees as independent contractors to avoid the complexities and costs of payroll taxes. Some small business owners will try to justify the misclassification by saying "They take home more money as a contractor" or "It's up to them to pay their taxes," but this approach exposes the employer to significant risks and can be seen as taking advantage of the worker.

Before you determine which classification is correct for your workers, let's consider how The Department of Labor (DOL) defines these roles under the Fair Labor Standards Act (FLSA).

Employee	Independent Contractor
An employee is someone who, as a matter of economic reality, is economically dependent on the employer for work. The employer controls how, when, and where the work is done.	An independent contractor is someone who, as a matter of economic reality, is in business for themselves and is NOT economically dependent on the employer. They typically control their own work and have the ability to earn profits or suffer losses based on how they manage their business.

If we breakdown these definitions, we can see that employees rely on the employer to provide them with a clearly defined role within the company, guidance on how to uphold their responsibilities, a location to work, as well as the tools and resources necessary to succeed.

Independent contractors rely on themselves to complete a specific job or function for the employer--they define their own role, decide how to uphold their responsibilities, set their own schedule, and acquire their own tools and resources.

Still confused and not sure which classification to choose? You're in luck! The DOL offers a six-factor test to help you make the right decisions.

The Six-Factor Test for Worker Classification

According to the DOL's 2024 rule, there are six factors used to determine whether a worker is an employee or an independent contractor.

1. Opportunity for profit or loss depending on managerial skill

2. Investments by the worker and the employer

3. Degree of permanence of the work relationship

4. Nature and degree of control

5. Extent to which the work performed is an integral part of the employer's business

6. Skill and initiative required

Opportunity for Profit or Loss Depending on Managerial Skill

Does the worker make decisions that impact their earnings, such as setting rates, hiring help, or advertising their services? If the answer is yes, the worker is likely an independent contractor. Workers who simply work more hours to earn more money (without making any strategic business decisions), are typically considered employees.

Example: A landscaper who chooses jobs, negotiates contracts, and markets their own services is an independent contractor. One who only accepts jobs assigned by a company and doesn't make any strategic business decisions is likely an employee.

Investments by the Worker and the Employer

This factor looks at whether the worker makes capital or entrepreneurial investments--not just buying small tools, but investing in things that support a business (equipment, software, office space, marketing). Employees rarely make investments into the business that go beyond performing in their role.

Example: A graphic designer using their own software, equipment, and office while advertising their services likely qualifies as an independent contractor. One who relies on the employer's equipment and doesn't market themselves is likely an employee.

Degree of Permanence of the Work Relationship

The nature and duration of the relationship between worker and employer is the next factor. It considers the length and exclusivity of the work arrangement. Independent contractors are usually hired sporadically or for project-based work, where the worker chooses the client. Whereas employees perform ongoing work exclusively for a single employer.

Example: A cook working regularly and only for one event venue over several years is likely an employee. But a cook providing services to various clients on a per-event basis would be considered an independent contractor.

Nature and Degree of Control

Who controls the work? The fourth factor looks at scheduling, supervision, pricing, ability to work for others, and whether the business sets the terms. If the employer is in control of these aspects, and has the authority to manage how the work is completed, the worker is probably an employee. Independent contractors typically set their own terms and manage how the work is completed.

Example: A nurse who is told when and where to work and is restricted from working for competitors will be classified as an employee. But a nurse who sets their own prices, manages their own schedule, and serves multiple clients should be classified as an independent contractor.

Extent to which the Work Performed is an Integral Part of the Employer's Business

Another factor in determining a worker's classification is whether their job is central to the employer's core operations. Employees keep a business running--their work is critical and necessary to maintain operations. The work of an independent contractor is usually supplemental or tangential, meaning its not critical or necessary to keep the business running.

Example: Tomato pickers at a tomato farm are integral to the business and are likely employees. An accountant who is hired seasonally to file taxes is not central to farming operations and would probably be considered an independent contractor.

Skill and Initiative Required

The sixth and final factor looks at skills and initiatives required of the worker. It is understood that all workers must provide some level of skill. Independent contractors use their skills in combination with business strategy, whereas employees use their skills at the direction of the employer.

Example: A welder who markets their own services and seeks multiple jobs shows business initiative, which would classify them as an independent contractor. But a welder who follows instructions from a single employer without seeking new business would be classified as an employee.

It's important to keep in mind that this is a totality-of-the-circumstance approach. There isn't one factor in the list of six that will determine the worker's classification. When deciding how to classify your workers you should take all six factors into consideration.

The Cost of Misclassifying Your Workers

Misclassifying workers to avoid payroll taxes is not only illegal--it's unfair. It places the full tax burden on the worker while expecting an employee-level commitment.

How it Effects the Worker

Employees who are misclassified as independent contractors are denied access to essential benefits. Being misclassified means they will not be eligible for unemployment insurance, worker's compensation, healthcare, or employer-paid taxes.

Independent contractors have the ability to mitigate their tax liability by reducing profit with qualifying expenses, whereas employees do not. If an employee is misclassified as an independent contract they typically end up paying more in taxes, because the employer isn't paying their share and the worker has no expenses to reduce profit.

How it Effects the Employer

If it is determined that an employee has been misclassified as an independent contractor, the employer may be liable for unpaid employment taxes, including Social Security, Medicare, and unemployment insurance, going back several years. Neglecting to classify workers properly can place the employer in hot water with multiple agencies, including the IRS and DOL, as well as state labor departments, resulting in additional filings and penalties.

How it Effects the Economy

When an employee is classified as an independent contractor it undermines fair labor standards and social insurance programs, such as unemployment insurance, Social Security, and Medicare--creating an uneven playing field for workers. Refusing to provide qualified workers the benefits they deserve widens the tax gap and places a larger burden on compliant businesses and workers.

Is it Worth the Risks?

At Basswood, we believe in helping businesses operate with clarity and integrity. That means making informed decisions not just about financial strategy, but about how people are treated within an organization.

When it comes to worker classification, our position is clear: Misclassifying an employee as an independent contractor is a legal, financial, and ethic risk that far outweighs any short-term savings.

How to Stay Compliant and Do the Right Thing

Misclassifying a worker isn't just a paperwork error--it's a risk that can damage your business and reputation. Fortunately, staying compliant is achievable with the right knowledge and proactive steps.

Learn the Classification Criteria

As we have reviewed, the DOL provides clear frameworks for determining whether a worker is an employee or an independent contractor. Using the six-factor test you can make sure you choose the correct classification for you worker, and avoid unnecessary penalties.

Keep Detailed Documentation

Maintaining written contracts, job descriptions, and policies for classifying workers can protect you in the event of an audit or legal challenge. You should outline job descriptions that include terms of work, payment structure, and expectations for each employee, so everyone clearly understands the arrangement. It's best to avoid language that implies control or permanence if the worker is a contractor--these relationships are usually documented in the form of a service agreement, contract, or invoice, rather than a job description.

Find a Financial Partner

Worker classification can be tricky, and the rules do change from time-to-time. Having a trusted financial partner to guide you on best practices will help keep your business stay in compliance. At Basswood we offer complete payroll processing services that include worker classification assistance. We ensure your employees and contractors are correctly compensated--withholding and remitting applicable payroll taxes to keep you in good standing with state and federal agencies.

Hire with Clarity. Lead with Integrity.

Understanding the difference between an employee and an independent contractor isn't just about avoiding penalties--it's about building a fair, sustainable business. By classifying workers correctly, you protect your business, your team, and your reputation. At Basswood, we help growth-minded small business owners like you navigate the complexities of payroll, compliance, and ethical hiring practices.

Set Up for Success

Schedule a free consultation with us today, and discover how our team of experts can help you to take your business to the next level.