The main difference comes down to control. Employees work under your direction. You tell them when to work, where to work, and how to do the job. Contractors control how they complete the work. You define the end result, but they decide their own methods and schedule.

The IRS evaluates three factors when determining classification. Behavioral control asks whether you direct what the worker does and how they do it. If you provide training, set schedules, and dictate procedures, that points toward employee. Financial control looks at whether the worker has unreimbursed expenses, can work for other clients, and bears their own financial risk. Contractors typically have their own tools, serve multiple businesses, and can profit or lose money on a job. The relationship type considers things like benefits, permanence, and written agreements.

The practical differences are significant. For employees, you withhold federal and state income taxes, Social Security, and Medicare from each paycheck. You pay the employer portion of payroll taxes, California unemployment insurance, and workers’ comp premiums. You file quarterly reports and issue W-2s at year end. If you need help getting this right from the start, payroll setup and training can save you from costly mistakes down the road.

For contractors, the paperwork is simpler. You pay the full invoice amount with no withholding. They handle their own taxes. At year end, you send 1099s to anyone you paid $600 or more. No quarterly payroll reports, no workers’ comp coverage required.

California makes classification harder under AB5. The state presumes workers are employees unless you can prove three things: the worker is free from your control, performs work outside your usual business, and has an independently established trade. Many workers who might qualify as contractors under federal rules are employees under California law. San Diego businesses need to be especially careful here.

Misclassification is expensive. If the IRS or California EDD reclassifies your contractors as employees, you owe back taxes, interest, and penalties. You may also face back wages, unpaid benefits, and workers’ comp liability. Some businesses have faced six-figure bills for misclassifying just a few workers over several years.

The cost difference between employees and contractors is real, but classification should follow reality, not preference. A San Diego bookkeeper who understands worker classification can help you track labor costs correctly and flag potential issues before they become problems. Choose based on what the working relationship actually looks like, not which option seems cheaper on paper.