Small Business Is Using More Contractors

Like larger corporations, many small businesses are using outside help rather than hiring new employees.

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By Scott Shane

Opinions expressed by Entrepreneur contributors are their own.

When commentators discuss the trend towards increased use of independent contractors at American companies, they tend to focus on large businesses. That's natural since information on what big companies do is easiest to access. However, in recent years, small business owners have also boosted their use of contract workers.

When business owners need others to work for them, they can take on employees or hire contractors. While the rules for using the two are different, both types of workers provide the labor that business owners need to run their companies.

While no government data measures use of contract workers by all small businesses, Internal Revenue Service data on sole proprietorships provide some insight into this question. Because sole proprietorships make up roughly three quarters of all companies, trends at those entities tend to be found among all small businesses.

Data show a rise in the fraction of sole proprietorships' business expenses that comes from contract labor annually, beginning in 2003, when the IRS first began recording those numbers, and ending 2011, the latest year that data are available. During this time, spending on contract labor rose from 3.5 percent of sole proprietors' business expenses in 2003 to 6.4 percent in 2011. The increased spending on independent contractors has occurred even as spending on salaries and wages declined, and the fraction of business expenses that goes to employee benefits remained flat, suggesting that all the growth in proprietors' spending on labor in recent years was concentrated on contractors.

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Sole proprietors' trend toward increased use of contract labor might predate 2003. While the IRS data do not show sole proprietors' expenditures on independent contractors in earlier years, they document spending on salaries and wages, which has been falling. Back in 1995, sole proprietors spent 16.4 percent of their total expenditures on wages and salaries, as compared with 13.2 percent in 2011. While proprietors' reduced spending on wages and salaries does not necessarily mean they increased spending on contract labor, it is consistent with such a trend.

So why are small business owners boosting their use of contract workers? Part of the answer is similar to the reasons why large companies are turning to them. Hiring independent contractors enhances flexibility. In recessions, contractors can be laid off more easily than employees. Conversely, in expansions, they can be added faster.

In addition, companies can try out potential employees as independent contractors. If they aren't a good fit, the business doesn't need to fire them. It can just fail to renew the contract. If the contractor is a match, then the company can take the person on as an employee.

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Small businesses have been turning to independent contractors for other reasons as well. One is to hire specialists at a reasonable cost. For many business functions – like human resources or accounting – small companies aren't large enough to justify bringing specialists in house full time, but demand the skills that those people can provide. Taking on contract workers provides a way to tap skills that the company would otherwise be unable to access.

Another reason for the turn to contractors is to control benefits costs, which have been rising very rapidly in recent years, particularly at small businesses. Because contract workers don't receive company benefits, like employee health insurance, small business owners can stem the rise in benefits costs by turning to contract workers in place of workers.

Whatever the reasons, small business owners are boosting their use of independent contractors. If that trend continues, hiring at small companies may remain soft in years to come.

Related: Would a Higher Accredited-Investor Threshold Clip Angels' Wings?

Scott Shane

Professor at Case Western Reserve University

Scott Shane is the A. Malachi Mixon III professor of entrepreneurial studies at Case Western Reserve University. His books include Illusions of Entrepreneurship: The Costly Myths That Entrepreneurs, Investors, and Policy Makers Live by (Yale University Press, 2008) and Finding Fertile Ground: Identifying Extraordinary Opportunities for New Businesses (Pearson Prentice Hall, 2005).

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