How to Convert a Contractor to an Employee: A Guide for US Businesses

Businesses that work with a global workforce often have to decide when to convert a contractor to an employee. Hiring contractors is great for short-term projects, but if their performance always meets (or exceeds) your expectations, you can bring them on board as full-time employees.

However, in the US, you need to consider many factors before undergoing this transition. Converting a contractor to an employee affects your budget, payroll and taxes management, team dynamics and obligations around employee benefits. You also have to draw a proper worker classification to stay compliant with all the federal and state regulations.¹

In this guide, we discuss how to convert contractors to employees and the right salary negotiation approach. We also learn the step-by-step process to ensure a smooth and compliant transition. We'll also talk about BatchTransfer, which can help your team send international business payments at low cost.

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Differences Between Independent Contractors and Full-time Employees

Contractors are self-employed professionals who take on specific projects or tasks. They often work for multiple clients simultaneously during their own working hours, using their own resources. They are responsible for their taxes and benefits and don’t depend on clients or employers for such things.

In contrast, full-time employees are integrated into the company’s daily operations. As an employer, you control when, where and how they work, and what benefits they qualify for (health insurance, worker’s compensation coverage, etc). Employees have taxes withheld from their paychecks, and employers contribute to Social Security, Medicare and unemployment insurance on their behalf.

As an employer operating in the US, you should be aware of these differences. The Internal Revenue Service (IRS) and Department of Labor (DOL) determine worker classification based on these factors.² If these institutions detect any sort of misclassifications, your business might be charged with fines, back taxes or other legal trouble.

Why Should You Convert a Contractor to an Employee?

Companies that decide to convert a contractor to an employee often have an edge over those that skip this transition. Below are some benefits of bringing contractors on as employees:

Legal Compliance and Risk Reduction

In the US, federal and state agencies closely scrutinize worker classification. Misclassifying someone as a contractor who should legally be an employee can lead to severe penalties, including fines, back taxes and interest payments.

It can also trigger audits with the IRS. You may end up paying unpaid payroll taxes, penalties and even retroactive benefits like unemployment insurance and worker’s compensation.

Access to Employee Benefits

Unlike contractors, employees typically receive a suite of benefits to protect their health, financial security and overall well-being. Offering health insurance is often a key motivator for conversion, especially under the Affordable Care Act (ACA).³ It requires employers with 50 or more full-time equivalent employees to provide health coverage or face penalties.

Employees also gain access to worker’s compensation insurance, which covers medical expenses and lost wages resulting from workplace injuries or illnesses.⁴ This benefit is not extended to contractors, shifting liability and risk onto the employer if the contractor is misclassified.

On the other hand, paid time off (vacation, sick leave), retirement plans (like 401(k)), family leave and other perks can improve job satisfaction and loyalty.⁵ These benefits encourage employees to stay longer and maintain higher productivity.

When contractors are converted to employees, businesses gain more control over work processes, quality and scheduling. Employees operate under your supervision and follow company policies. This control is difficult to enforce with contractors, whose independent status legally limits your authority over their methods or work hours.

Employees also integrate more fully into your company culture. This leads to stronger teamwork, better communication and alignment around company goals.

Financial Predictability and Budgeting

Another benefit to convert a contractor to an employee is increased financial predictability. Contractors are often paid hourly or per project, which can lead to fluctuating expenses dependent on workload. Employees receive a fixed salary, making budgeting easier and more stable.

Yes, hiring full-time workers involves additional costs, such as payroll taxes, benefits administration and insurance. However, these expenses contribute to better workforce stability that can lower turnover-related costs over time.

Improved Talent Retention and Morale

When a contractor becomes an employee, they gain job security, additional benefits and more career development opportunities. This change of status boosts their morale and reduces turnover.

Acquiring the employee status also creates a sense of belongingness. From a business perspective, this transition reduces recruitment and training costs while building a more resilient and skilled team.

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7 Steps to Convert Contractor to Employee

Businesses should have a well-defined strategic plan when converting a contractor to a full-time employee. Here’s a detailed step-by-step guide to help you navigate this process smoothly.

1. Evaluate the Contractor Role and Your Business Needs

Start by assessing the current role the contractor plays in your business. Ask yourself:

• Is this work ongoing and consistent, or project-based and temporary?
• Has the contractor been working exclusively or almost exclusively with your company?
• Does the contractor follow your schedules, use your tools or systems or work under your direct supervision?
• Do you foresee a long-term need for this role within your team?

If the contractor fits more with a steady, integral role rather than a flexible or freelance setup, converting them to a full-time employee might be the best option.

2. Review Local Labor Laws and IRS Guidelines

The IRS has clear criteria to determine when a contractor should be classified as an employee.⁶ Some key factors of their evaluation include:

• Behavioral Control: How much control do you have over what, when and how the work is done?
• Financial Control: Are you controlling how the worker is paid and whether expenses are reimbursed?
• Relationship Type: Is there a written contract, provision of employee-type benefits or a permanent relationship?

Besides federal guidelines, you should also familiarize yourself with state-specific labor laws, as they vary greatly and may impose stricter rules.

Local labor laws can be complex and deter your company from wanting to hire an employee abroad. A few options are available to simplify this process:

1. Employer of record (EOR)
2. Professional (Professional employment orgnaization)
3. Establish a local business entity

3. Communicate Intent and Negotiate Terms With Your Contractor

Before making any formal changes, have an open and honest conversation with the contractor. Some key topics of discussion should focus on the reasons for converting their status, including compliance, mutual benefit or business growth.

The contractor may also be interested in knowing the proposed salary and benefits, as well as any changes in job expectations, work hours and reporting structure. Clear communication sets a positive tone for the new working relationship.

4. Draft a New Employment Contract

Once terms are agreed upon, prepare a formal employment agreement. While contractor agreements mainly focus on deliverables and payment schedules, employee contracts cover a broader range of responsibilities and protections.⁷

A comprehensive employment contract should have:

• Job title and detailed responsibilities
• Salary amount, pay schedule and any bonuses or commissions
• Benefits overview, including health insurance, worker’s compensation and retirement options
• Work schedule, location and expectations on hours
• Terms concerning termination or resignation procedures
• Any company policies that the employee will be bound by, such as confidentiality and intellectual property clauses

5. Update Payroll Systems and Tax Documentation

Converting a contractor to an employee completely changes your payroll and tax processing. As a contractor becomes an employee, they will need to fill out Form W-4 for federal tax withholding.⁸ Meanwhile, the employer will be responsible for withholding and submitting income taxes, Social Security, Medicare and unemployment insurance taxes on their behalf.

Your payroll system should be able to deduct applicable taxes and track hours or salary accurately. It must also provide pay stubs and report payroll information to tax authorities on time.

You’ll also need to register the new employee for worker’s compensation insurance if your state requires it.

6. Onboard Your New Employee

Now comes the part where you officially welcome the contractor as an employee and introduce them to your team.

During onboarding, guide the employee about your company’s mission, values and key team members. You should also provide access to insurance and benefits enrollment.

Moreover, teach them about employee policies and procedures, including time-off requests, workplace conduct and performance reviews. Doing so will make the new employee feel valued and prepared for what’s coming ahead.

7. Monitor Compliance Continuously

Worker conversion isn’t a one-time event. You need to regularly review your workforce to ensure classifications remain accurate as roles change.

Keep detailed records of employment agreements and amendments, payroll and tax filings and benefits enrollment and usage. You should also document worker’s compensation claims or certifications.

Remember to stay informed about changes in labor laws and IRS regulations to avoid legal troubles down the road.

How to Negotiate Salary When Converting From Contractor to Employee

Salary negotiation is the trickiest part of converting contractors to employees. Contractors are usually paid hourly or by project, while employees receive a stable salary plus benefits.

When converting from contractor to employee salary, consider the value of added benefits, such as health insurance and paid time off. You don’t necessarily need to match the hourly contractor rate, but you should calculate a fair salary that reflects both pay and benefits.

Here’s a simple method to calculate a salary offer from a contractor’s hourly rate:

• Estimate the contractor’s hourly rate and work hours. Suppose your contractor currently earns $40 per hour and typically works 40 hours per week.
• Research comparable full-time salaries. You find that similar full-time roles in your industry and location pay around $80,000 annually.
• Now, use a 40-hour workweek as a standard to convert these salaries to hourly rates by dividing annual salaries by 52 weeks and then by 40 hours. For instance, divide $80,000 by 52 weeks = approximately $1,538 per week. Then, divide $1,538 by 40 hours = about $38.45 per hour.
• Assume the value of benefits adds roughly 25% to the base pay. 25% of $38.45 = $9.61 per hour in benefits.
• Now, add hourly salary and benefit rates. $38.45 + $9.61 = $48.06 total hourly compensation value.
• Finally, calculate the annual salary based on expected hours. Multiply $48.06 by 40 hours per week = $1,922.40 per week. Then, multiply $1,922.40 by 52 weeks = approximately $99,960 per year.

Don’t forget to add the new employee to your payroll system to withhold the correct taxes and pay them timely. If you use time and attendance software, add the employee there as well so they can easily clock in and out.

When Should You Consider Converting Contractors to Employees?

The decision to convert a contractor to an employee depends on how your business evolves and what your operational needs look like.

If a contractor has been working consistently with your company for two years or more, this aligns with the “2-year contractor rule.” This unofficial guideline suggests that if a contractor’s engagement approaches or exceeds two years, it’s time to seriously evaluate whether their status should be shifted to employee.

Another sign to convert contractors is when their responsibilities become central to your day-to-day operations, rather than being project-based or occasional. If a contractor is handling your essential workflows regularly, welcoming them as an employee can bring continuity, better integration and stronger oversight.

Compared to independent contractors, employees are more invested in your company’s success because they enjoy benefits and job stability. They also provide more predictability and reliability to support smoother business expansion and consistency.

Frequently Answered Questions

Can a contractor become an employee?

A contractor can become an employee. The IRS defines criteria that measure behavioral control, financial control and the nature of the relationship to decide if a worker should be classified as an employee.

Can a contractor refuse to become an employee?

Yes, a contractor can choose not to accept an employee position since the conversion requires mutual agreement. Forcing the change without consent can harm your professional relationship and may lead the contractor to seek other opportunities.

What happens if I don’t comply with employee classification rules?

Non-compliance can result in significant penalties, including fines, back taxes and interest payments. It can also expose your business to lawsuits and the obligation to provide retroactive benefits like worker’s compensation and unemployment insurance.

Is the 2-year contractor rule legally binding?

No, the 2-year contractor rule is just an informal guideline. If you’re working with a contractor for two years or more, you must reassess their classification to avoid potential misclassification risks.

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Sources:

1. Worker Classification 101: employee or independent contractor | IRS
2. Fact Sheet 13: Employee or Independent Contractor Classification Under the Fair Labor Standards Act (FLSA) | US Department of Labor
3. About the Affordable Care Act | US Department of Health and Human Services
4. Workers’ Compensation Insurance | Workers’ Compensation Board NY
5. Employee Benefits in the United States Summary | US Bureau of Labor Statistics
6. Independent contractor (self-employed) or employee? | IRS
7. Contracts of Employment: A Comprehensive Guide | Indeed
8. Form W-4 - Employee’s Withholding Certificate | IRS