What is the difference between a contractor and an employee: Who gets paid for what

Way back, I wrote about how to estimate rates for an employee, and a contractor.

Since then I’ve gotten questions on the difference between the two and why there is such a big difference. I thought I had covered the difference but let’s do it yet again.

So starting from the basic hourly rates, let’s look at what is built into each of the rates and what is considered extra. Remember that for both rates you will be dividing the amount per year by the number of hours.

First off, an individual can easily move from employee to freelance contractor and back again. So the rates need to balance out.

Both employee and contractor need to start from the same salary amount. Otherwise people will only accept one or the other. For ease of calculation let’s say that amount is $100,000.

The second element is benefits. Benefits are extra items which are paid by the employer for the employee. Examples are pension plans ( including 401K, RRSP and other contributions), group insurance and additional (non-government health plans). With employees these amounts are extra to the hourly rate (and the salary). (By the way, if you cut the benefits you’ll need to increase the salary to stay in the market). With a contractor this amount must be built into the rate as they pay for their own benefits.

The third element of cost are the employment taxes. These are company portions of amounts which are mandated by the government. For example, government pension (CPP/QPP in Canada & Social Security in the U.S.) are taxes paid by both the employee and employer. Unemployment insurance (EI in Canada), Workers Compensation and public health programs (e.g. OHIP in Ontario) are three other costs. These are paid seperately for an employee by the employer. However, the costs must be built into the rate for a contractor. It is the contractor who will be paying those costs.

The denominator (i.e. the hours) also shows a similar difference between Employee and Contractor.

The basic number of work hours in a year is the same for both.

From that is deducted three types of labour.

The first is vacation and statutory holidays. An employee continues to be paid for that time. So their rate doesn’t need adjustment for those days. On the other hand, a contractor does not get paid for those days and their rate needs to be adjusted to provide for vacation and statutory holiday pay.

The second is personal time off. Neither hourly employees nor contractors get paid for this time. So both rates need to be adjusted to provide for this.

The third time adjustment is for “non-billable” time. This is time which the contractor spends but cannot bill for. In the case of an employee, this is always a zero amount. However, a contractor needs to provide for this time in his or her rate as they can’t bill for it (thus non-billable).

As you can see, in order to pay employees (salaried or hourly) and contractors the same amount the rate per hour needs to be radically different. (Contractor rate is roughly double hourly employee rates in order to give the same salary amount).

There are two additional elements that the freelance contractor needs to include in his or her rate. The first is the cost of running his or her business (i.e. the overheads) and the second is the profit or return for accepting the risks associated with running a business. Although I’ve ignored those amounts in my calculations, it is important not to discount them. They can represent quite sizeable necessary adjustments to the rates for contractors.

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