What Difference Does it Make – Contractors vs Employees

For hundreds of years human ingenuity has been creating new businesses and even new industries. Today our lives are made easier by personal computers, cell phones, airplanes, automobiles, air conditioners and hundreds if not thousands of products and services that never existed before. So I typically applaud new businesses and new industries as demonstrative of the progress of mankind. They are good for the economy, good for the people and good for the business founders. Win, win, win.

But not all of these new industries are good for us. Today an industry has been spawned to differentiate contractors from employees. Do a Google search on contractors vs employees and you’ll find somewhere over 17 million results. Accountants, attorneys, consultants, HR experts and even the government fill the Internet with content to educate you as to the difference between contractors and employees, and many of the websites warn of the dire consequence to you, the business owner, should you misclassify someone who is paid by you for their services. The Supreme Court has even opined on the difference between a contractor and an employee.

Why all of the controversy and how did this all start? Ever read any history books or historical novels? Did you ever read about contractors and employees in Roman or Greek times, in the Bible, in the history of England, or Germany or China? Charles Dickens wrote extensively about the business world in the 1800s but never discussed contractors and employees. Why? Because there is no difference between a contractor and employee. At least there was no difference, until the federal and state governments got involved.

Historically, when one person worked for another person, that person got paid for his/her services based upon the agreement between the person doing the paying and the person getting paid. The agreement may have covered an hour, a day, a week, a year or longer. It may have included compensation in the form of cash, food, housing, use of livestock and use of land. There were only two parties to all such engagements – the person doing the hiring and the person being paid for his or her work.

Today that relationship has somehow changed. We still have on one side the person paying for the work. But on the other side we have broken down the people being paid for their work into employees and contractors. How do you know the difference? Well, often it is really difficult to know, but if you want to figure it out, you must refer to a stack of publications, rules and interpretations issued by various government entities. Or you can hire a consultant, an attorney or perhaps an accountant who can try to steer you in the right direction. And if for any reason you don’t figure this stuff out correctly, the government could put you out of business. How and why did this happen? Well, that’s the story.

Prior to 1940 individuals paid their taxes to the government in installments, typically on a quarterly basis. But in the 40s, as the government’s expenditures went up due to World War II, the government decided it could collect tax faster, and easier, by making employers take the tax out of the employee’s paycheck and then remit that tax directly to the government. After all, it’s much easier to chase a few million employers than 150 million tax paying individuals.

Then the government also decided that in addition to the tax owed by the employee, the government was going to tax the business for having that employee. So each payday every company that has employees would have to pay to the government a tax on the employee’s income, and a tax on the business for the privilege of having an employee (we now call these payroll taxes). It didn’t take the states long to figure out the system and before long most states duplicated the federal system, so that today a business with employees typically pays tax on behalf of the employee to the both the state and federal government, and a tax for the privilege of having an employee to both the state and federal government.

At some point after the government decided to force businesses to collect tax on the government’s behalf and before the government decided to tax businesses for the privilege of having employees, both employees and employers realized that the relationship between the person who pays for the work and the person who gets paid for the work, varies from situation to situation.

As an example, if I want a bookkeeper I could hire a bookkeeper. But I could also engage the services of a bookkeeping business to do my books, even if that bookkeeping business is a one-man show. If I hire the bookkeeping business I don’t have to deduct taxes and pay for the privilege of hiring the bookkeeping business. Thus, according to the government, the bookkeeping business is a contractor, not an employee, even if the bookkeeping business in a non-incorporated individual with only one customer.

Now this is where things get murky. Many employees would prefer to be contractors for a variety of reasons, such as the ability to work for more than one employer, doing freelance work, operating their employment as a small business, and of course, not being subject to withholding tax. Many employers would also like some of their employees to work as contractors for a variety of reasons, such as the ability to use freelance labor, the ability to grown and shrink the labor force based upon need, and the simplicity of hiring contractors versus employees (hiring an employee not only subjects a company to complex and onerous labor laws but further, requires the employer to complete complicated hiring form (I-9) and vet the employee to make sure he or she is legally allowed to work in the US, all of which can result in huge penalties, fines and even jail if not done correctly).

From an employer’s perspective, historically the distinction between an employee and a contractor was never made because the employer paid for the services and the worker provided the services, with no further thought about what you called the worker. But today it makes a huge difference. Why? Because the government realizes that its share of the economic pie is a whole lot bigger when your workers are employees, as opposed to contractors, and further, collecting the tax from workers is so much easier when you have employees as opposed to contractors. As a result, the government has done everything it can to narrow the definition of a contractor, and expand the definition of an employee. Now it has gotten so technical and complicated that it has spawned an entire industry, as mentioned at the beginning of this article. The government is so adamant that it wants you to classify your workers as employers as opposed to contractors, that if the government determines your contractors are really employees you can be subject to fines and penalties so horrific it could put you out of business.

So now, instead of spending time creating new products, improving existing products and services, and taking care of customers, business owners are spending millions upon millions of dollars and untold amounts of management time trying to understand the complex government regulations on what constitutes a contractor versus an employee, hiring experts to interpret those regulations and advise on those regulations and worrying about some government auditor arriving on the doorstep who starts handing out fines and penalties.

Worse, the attorneys, accountants, consultants, IRS employees, taxing authorities and others discuss this issue as if it were a natural function of our economic system when it is about as logical as flying pigs. The government created the distinction between employees and contractors, it has no natural source in either economics or business, and it exists solely to increase the bite the government takes out of the economy and to make it easier for the government to extract money from taxpayers.

I understand that the government needs to assess and collect taxes (note I use the word taxes—to make it sound nicer, government officials have taken to calling taxes “revenue” but revenue is something generated by combining materials and labor and then selling the end result at a profit to a willing buyer—taxes are not revenues). However in the issue of contractor vs employee, along with the tax employers must pay for the privilege of having employees (even if the company generates no profits or losses money) the government has placed a substantial burden on business, particularly small business. Today businesses are paying employee privilege taxes; paying fines and penalties for misclassifying workers under an artificial and bogus classification system; paying consultants, advisors and experts to provide guidance on compliance; and wasting management resources trying to figure this all out, rather than allowing management to focus on building the business enterprise, innovation and wealth creation.

The cost to our economy is in the many billions of dollars (probably hundreds of billions) and that spending creates no economic growth or value added for the enterprise, or the economy as a whole. And then some people wonder why our country’s economic growth rate is anemic. While I am sure the good folks who designed this whole mess did so with the finest of intentions, I suspect the most Machiavellian of minds could not conjure up a system so devious, unfair and nonsensical.

Author: Michael Manahan

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