Employee or Independent Contractor? A Simple Guide for Small Business Owners

Independent contractor or employee?

When you’re running a small business, it’s easy to view hiring as just another to-do list item. But one of the most important decisions you’ll make when bringing on help is how to classify your workers—as employees or independent contractors. Get it wrong, and you could face serious consequences, from tax penalties to legal disputes.

So, how do you know which classification is correct for your business? This guide breaks down the key differences and gives you a simple, practical framework to help you make confident decisions. The content of this article is intended to provide general information, and it is important to note that other factors, such as state specific regulations, may be applicable in your situation.

Why Classification Matters

Worker classification isn’t just paperwork—it impacts your legal responsibilities and financial obligations. The classification affects:

• Whether you’re responsible for withholding and paying payroll taxes

• Whether the worker is eligible for company-provided benefits

• Which employment laws apply (like minimum wage, overtime, and leave)

• Whether your business must provide workers’ compensation or unemployment insurance

Misclassifying a worker—intentionally or not—can result in back taxes, fines, interest, and potential lawsuits. According to the IRS, misclassification is one of the most common compliance issues small businesses face.

Key Differences Between Employees and Independent Contractors

At the core, the difference between an employee and an independent contractor is typically about control—who directs the work and how it’s performed. Here are the major distinctions:

• Control and Direction: Employees follow your schedule and perform tasks the way you instruct. Independent contractors decide how and when to do the work.

• Tools and Equipment: Employees use tools, equipment, or software that you provide. Contractors typically use their own.

• Training and Supervision: Employees often receive training, policies, and ongoing direction. Contractors are already trained professionals working independently and do not receive company handbooks.

• Exclusivity: Employees usually work only for your business. Contractors may serve several clients at once.

• Compensation Structure: Employees are paid hourly, salary, or commission. Contractors invoice by the project or deliverables.

• Taxes and Withholding: Employers must withhold income and payroll taxes for employees. Contractors are responsible for their own taxes and receive a 1099 form.

• Benefits Eligibility: Employees may qualify for benefits such as health insurance or paid time off. Contractors do not receive benefits.

  
  

Understanding IRS and DOL Guidelines

To help you classify workers correctly, here are two examples of government agencies that provide specific criteria:

• The IRS Common Law Test looks at behavioral control (how much direction you give), financial control (who provides tools and manages expenses), and the nature of the relationship (benefits, duration, etc.).

• The Department of Labor’s Economic Reality Test asks whether the worker is economically dependent on your business or truly operating as their own business.

Additionally, some states use stricter tests, like the ABC Test, which presumes a worker is an employee unless all three parts of the test are met. For example, Montana Department of Labor generally requires independent contractors to either have an ICE-C or a workers compensation policy.

The takeaway: when in doubt, it’s safer to assume the worker is an employee—or consult with an accounting, HR, or legal professional for clarification.

Examples to Help You Decide

• Example 1: Independent Contractor

  You hire a freelance web designer to revamp your website. They work from home, set their own schedule, use their own tools, and invoice you at the end of the project. This person is likely a contractor.

  
  

• Example 2: Employee

  You bring on a part-time office assistant who works in your office three days a week, follows a set schedule, and uses your computer and systems. This worker is likely an employee.

  
  

Steps to Stay Compliant

To avoid misclassification and protect your business, take these steps:

1. Use written agreements that clearly define the worker’s role, payment terms, and classification.

2. Avoid managing contractors like employees. Don’t set specific hours, provide ongoing supervision or company handbooks/policies, or assign day-to-day tasks unless it falls within their defined scope of work.

3. Review your current worker relationships to ensure they align with classification rules.

4. Keep documentation that explains how you determined the worker’s status.

5. Consult with an HR consultant, accountant, or attorney when unsure—especially if the role has elements of both categories.

   
   

How an HR Consultant Can Help

Navigating worker classification can be confusing, especially when laws vary by state and role. That’s where an HR consultant comes in.

At Mountain HR Consulting, we work with small businesses to:

• Review job roles and contractor agreements for compliance

• Build consistent, legal hiring and onboarding practices

• Create templates and tools to keep classification decisions well-documented

  
  

Whether you're hiring your first team member or scaling quickly, we're here to help guide you through common legal pitfalls—and set up for long-term success.

About Us: At Mountain HR Consulting, we specialize in providing practical, affordable HR solutions tailored to small businesses in Montana, Idaho, Wyoming, North Dakota, and South Dakota. From employee handbooks and policy development to hiring support and compliance audits, we help you build a strong HR foundation without the overhead of a full-time team. Our services are designed to save you time, reduce risk, and support business growth. Let us handle your HR needs so you can focus on running your business with confidence.