Bringing in help is a big step for a small business. You can hire an employee or pay an independent contractor, and the choice changes your costs, your paperwork and how much control you have over the work. This guide explains how the two are told apart, compares what each really costs, and lists the forms each one needs.
The key difference: control
The label in your agreement doesn't decide whether someone is a contractor. What matters is how the relationship actually works. The IRS groups the evidence into three categories:
- Behavioral control. If you decide how, when and where the job is done, or train the worker in your methods, that points to an employee.
- Financial control. Contractors usually supply their own tools, set their own prices, work for other clients and can make or lose money on a job. Employees are typically paid a steady wage and reimbursed for expenses.
- Type of relationship. Benefits, an open-ended arrangement and work that is a core part of your business point toward employment. A defined project under a written contract points toward a contractor.
No single factor decides it. The IRS looks at the whole picture, and if you are still unsure you can ask it for a determination with Form SS-8.
State and labor law can be stricter
Federal tax rules are only one test. The Department of Labor asks whether the worker is economically dependent on you or truly in business for themselves, which matters for minimum wage and overtime.
Some states, including California, Massachusetts and New Jersey, use a stricter "ABC test" that starts by presuming the worker is an employee. Check your state's rules before you treat anyone as a contractor, especially for long-term or full-time work.
What each one really costs
A contractor's hourly rate looks higher, but it is usually all-in. An employee's wage is only the start, because you also pay the employer share of payroll taxes, benefits and overhead.
| Employee (W-2) | Contractor (1099) | |
|---|---|---|
| Employer payroll tax | 7.65% FICA, plus federal and state unemployment tax | None (they pay 15.3% self-employment tax themselves) |
| Benefits | Often health, retirement and paid time off | None |
| Equipment and training | Usually yours | Usually theirs |
| Paid when there is no work | Yes | No, only for work delivered |
| Your control over the work | High | Limited to the result |
Example
An employee paid $60,000 a year, with $12,000 of benefits and $3,000 of overhead, costs about $79,590 a year once 7.65% employer FICA is added. That is about $38 an hour over 2,080 hours. A contractor charging $55 an hour for 1,000 hours of actual work costs $55,000, with no payroll tax or benefits on top.
The contractor is cheaper here only because you pay for 1,000 hours instead of 2,080. At full time, the same contractor would cost $114,400, so the answer flips. Run your own numbers with the true cost of an employee calculator.
Paperwork for each
- Employees. Collect Form W-4, complete Form I-9, withhold income and payroll taxes, file quarterly Form 941 and give each employee a W-2 in January. Most states also require workers' compensation coverage and an unemployment tax account.
- Contractors. Collect Form W-9 before the first payment. For payments made in 2026, file Form 1099-NEC for each contractor you pay $2,000 or more during the year (the threshold was $600 through 2025).
Form 1099-NEC is due to both the contractor and the IRS by January 31 of the following year. Most payments to corporations don't need one, but payments for legal services generally do.
The cost of getting it wrong
If someone you paid as a contractor is really an employee, you can owe the payroll taxes you didn't withhold, plus penalties and interest. States can add unpaid unemployment tax, and the worker may be owed overtime or benefits.
If you find a mistake, the IRS Voluntary Classification Settlement Program lets eligible businesses reclassify workers going forward and pay a reduced amount of back payroll tax. A tax professional or employment attorney can tell you whether it fits.
Which should you choose?
- Choose a contractor for a defined project, specialized skills you need now and then, or work the person controls. You pay only for results.
- Choose an employee for ongoing, core work you want done your way and on your schedule. You gain control and continuity in exchange for higher fixed costs.
If you are the contractor, price your time so it covers your own taxes and unpaid hours. The freelance hourly rate calculator and the self-employment tax calculator show what you need to charge.