What is a Contract Employee? A Complete Guide for Small Business Owners
As your small business grows, you'll face important decisions about how to structure your workforce. Should you hire full-time employees, bring on part-time staff, or work with contractors? Understanding the different types of workers—particularly contract employees—is crucial for making smart hiring decisions that align with your business needs and budget.
Contract employees offer unique advantages for small businesses, but they also come with specific legal considerations and management challenges. This guide will help you understand everything you need to know about contract employees and how they might fit into your business strategy.
What is a Contract Employee?
A contract employee, also known as an independent contractor or freelancer, is a worker who provides services to your business under a contractual agreement rather than as a traditional employee. Unlike regular employees, contract workers are not on your payroll, don't receive employee benefits, and typically have more control over how and when they complete their work.
Contract employees are essentially running their own small businesses and providing services to yours. They're responsible for their own taxes, insurance, and business expenses, which can make them an attractive option for small businesses looking to access specialized skills without the overhead of traditional employment.
Contract Employee vs. Regular Employee: Key Differences
Understanding the distinction between contract employees and regular employees is crucial for legal compliance and business planning:
Employment Relationship
Regular Employees:
Work under your direct supervision and control
Follow company policies and procedures
Work set hours determined by the employer
Use company equipment and resources
Receive W-2 tax forms
Contract Employees:
Work independently with minimal supervision
Set their own methods and procedures
Control their own schedule and work location
Use their own equipment and tools
Receive 1099 tax forms
Benefits and Compensation
Regular Employees:
Eligible for company benefits (health insurance, retirement plans, paid time off)
Receive regular paychecks with taxes withheld
May receive overtime pay
Protected by employment laws and regulations
Contract Employees:
Not eligible for company benefits
Responsible for their own taxes and insurance
Paid per project or agreed-upon rate
Not covered by most employment laws
Types of Contract Employees
Project-Based Contractors
These contractors are hired for specific projects with defined deliverables and timelines. Common examples include web developers building a website, graphic designers creating marketing materials, or consultants conducting market research.
Ongoing Service Contractors
Some contractors provide ongoing services on a regular basis, such as bookkeepers who handle monthly financial tasks, content writers who create weekly blog posts, or virtual assistants who manage administrative duties.
Seasonal or Temporary Contractors
These workers help during busy periods or cover for absent employees. Examples include tax preparers during tax season, retail workers during holidays, or event staff for special occasions.
Specialized Skill Contractors
Highly skilled professionals who provide expertise your business lacks internally, such as IT specialists, marketing strategists, legal advisors, or industry consultants.
Benefits of Hiring Contract Employees
Cost Savings
Contract employees can be more cost-effective than regular employees because you don't pay for benefits, payroll taxes, unemployment insurance, or workers' compensation. You also avoid costs associated with office space, equipment, and training.
Access to Specialized Skills
Contract employees often bring specialized expertise that would be expensive to maintain full-time. You can access high-level skills for specific projects without the long-term commitment of hiring a specialist employee.
Flexibility and Scalability
Contract workers allow you to scale your workforce up or down based on business needs. You can bring in extra help during busy periods or for special projects without long-term commitments.
Reduced Administrative Burden
Contract employees handle their own taxes, insurance, and benefits, reducing your HR and administrative workload. This is particularly valuable for small businesses with limited administrative resources.
Fresh Perspectives
Contract employees often work with multiple clients and bring diverse experiences and innovative approaches to your business challenges.
Potential Drawbacks and Challenges
Less Control Over Work
Contract employees have more autonomy in how they complete their work, which means less direct control over methods, timing, and quality standards.
Limited Availability
Contract workers may have other clients and commitments, potentially making them less available when you need immediate assistance or have urgent projects.
Knowledge Transfer Issues
Contract employees may not develop the same deep understanding of your business as regular employees, and their knowledge leaves with them when projects end.
Potential Legal Risks
Misclassifying employees as contractors can result in significant legal and financial penalties from tax authorities and labor departments.
Communication Challenges
Managing remote contract workers requires different communication strategies and tools compared to in-office employees.
Legal Considerations and Compliance
IRS Classification Tests
The IRS uses three main criteria to determine worker classification:
Behavioral Control:
Does the company control how the worker performs their job?
Are there detailed instructions about methods and procedures?
Does the company provide training?
Financial Control:
Does the worker have unreimbursed business expenses?
Do they have the opportunity for profit or loss?
Can they work for other companies?
Relationship Type:
Are there written contracts describing the relationship?
Does the company provide employee benefits?
Is the work performed integral to the business?
State-Specific Laws
Many states have their own tests for worker classification, which may be more restrictive than federal guidelines. California's AB5 law, for example, uses the "ABC test" that makes it harder to classify workers as contractors.
Consequences of Misclassification
Incorrectly classifying employees as contractors can result in:
Back payment of payroll taxes and penalties
Payment of unemployment insurance and workers' compensation
Providing retroactive benefits
Legal fees and potential lawsuits
How to Hire and Manage Contract Employees
Step 1: Define Your Needs
Clearly identify what work needs to be done, required skills, project timeline, and budget. This helps determine whether a contractor is the right solution.
Step 2: Find Quality Contractors
Online Platforms:
Upwork, Freelancer, and Fiverr for various skills
99designs for graphic design work
Toptal for high-end technical talent
LinkedIn for professional services
Professional Networks:
Industry associations and events
Referrals from other business owners
Local business groups and chambers of commerce
Step 3: Create Clear Contracts
Your contract should include:
Detailed scope of work and deliverables
Payment terms and schedule
Project timeline and milestones
Intellectual property ownership
Confidentiality agreements
Termination clauses
Step 4: Establish Communication Protocols
Set up regular check-ins, preferred communication methods, and project management tools to stay connected with remote contractors.
Step 5: Manage Performance
Focus on results rather than methods. Provide clear expectations and feedback while respecting the contractor's independence.
Best Practices for Working with Contract Employees
Set Clear Expectations
Communicate project requirements, deadlines, quality standards, and communication preferences upfront to avoid misunderstandings.
Use Written Agreements
Always have written contracts that clearly define the working relationship, scope of work, and payment terms. This protects both parties and helps establish the independent contractor relationship.
Respect Their Independence
Allow contractors to work in their preferred methods and locations. Avoid micromanaging or treating them like regular employees.
Pay Promptly
Maintain good relationships by paying contractors on time according to your agreed terms. Consider using automated payment systems for recurring work.
Provide Necessary Information
Give contractors access to the information and resources they need to complete their work successfully, while maintaining appropriate confidentiality measures.
Plan for Knowledge Transfer
For important projects, ensure contractors document their work and transfer knowledge before projects end.
When to Choose Contract Employees vs. Regular Employees
Choose Contract Employees When:
You need specialized skills for short-term projects
Work volume fluctuates significantly
You want to test new roles or services
Budget constraints limit full-time hiring
Work can be done remotely and independently
Choose Regular Employees When:
You need ongoing, consistent work
The role requires deep company knowledge
You need direct control over work methods
The position is integral to daily operations
You want to build long-term team culture
Managing Taxes and Payments
1099 Forms
You must provide Form 1099-NEC to contractors who earned $600 or more during the tax year. File these forms with the IRS by January 31st.
Payment Processing
Consider using payment platforms like:
PayPal or Stripe for online payments
QuickBooks for integrated accounting
Bill.com for automated contractor payments
Direct bank transfers for regular contractors
Record Keeping
Maintain detailed records of:
Contracts and work agreements
Payment records and invoices
Project deliverables and communications
Tax forms and compliance documentation
Common Mistakes to Avoid
Treating Contractors Like Employees
Don't require contractors to work specific hours, use company equipment, or follow detailed procedures that suggest an employment relationship.
Inadequate Contracts
Vague or missing contracts lead to disputes and legal issues. Always use comprehensive written agreements.
Poor Communication
Unclear expectations and infrequent communication result in unsatisfactory work and missed deadlines.
Ignoring Tax Obligations
Failing to issue 1099 forms or properly classify workers can result in significant penalties.
Not Vetting Contractors Properly
Hiring contractors without checking references, portfolios, or qualifications can lead to poor results and wasted money.
The Bottom Line
Contract employees can be a powerful resource for small businesses, offering access to specialized skills, cost savings, and operational flexibility. However, success with contract workers requires careful planning, clear communication, and strict attention to legal compliance.
The key is understanding when contract employees make sense for your business and how to manage them effectively. They're not a replacement for all regular employees, but they can be an excellent solution for specific projects, specialized tasks, or variable workloads.
Before hiring your first contract employee, take time to understand the legal requirements in your area, create solid contracts, and establish clear processes for finding, hiring, and managing contractors. When done right, contract employees can help your small business access talent and capabilities that might otherwise be out of reach, allowing you to compete more effectively and grow more efficiently.
Remember, the goal is to build a workforce structure that supports your business objectives while staying compliant with employment laws. Contract employees can be a valuable part of that structure when used appropriately and managed professionally.