|All content presented here and elsewhere is solely intended for informational purposes only. The reader is required to seek professional counsel before beginning any legal or financial endeavor.|
The correct classification of worker type is essential for legal and taxation purposes. If you get it wrong, there is no forgiveness. You will be fined heavily and can even be classified as a ‘tax evader’. You are breaking the law and costing yourself a lot of money by trying to save a few bucks with a wrongful classification.
This guide will help you to distinguish between the 1099 contractor and the W2 employee so you stay on the right side of the IRS. Let’s take a look at the two different kinds of the worker, the 1099 and the W2.
1099 vs the W2
A 1099 worker is also known as an independent contractor. They are not employees, they are contractors. As they are contractors, you are not responsible for giving them any benefits or for many of the standard protocols associated with employees. There is a significant amount of legislation governing how employers must treat their employees. But there is precious little in relation to independent contractors. This is why many businesses are tempted to classify workers as employees where possible. It’s just less red tape, more revenue, and zero hassle.
In contrast, the W2 worker is technically an employee of the business. You will give them fixed pay and the associated benefits. They will have standard working hours and you basically tell them what to do. A primary distinguishing characteristic between the 1099 contractor and W2 employee is that of freedom. You pay a contractor to do a job, and he or she does it depending on their expertise. A W2 worker gets paid a regular wage weekly or monthly, and you tell them exactly what to do in a more general sense.
Both the 1099 and the W2 workers get their names from the IRS tax form used to submit for each. Form 1099 is sent to the IRS for an independent contractor, and Form W2 is sent to the IRS for an employee.
The Test for the 1099 Worker
Numerous tests have evolved in order to distinguish 1099 from W2. Some factors are quite significant. However, it must be remembered that the courts will assess the situation as a whole before determining whether or not a worker is a 1099 contractor or a W2 employee.
The IRS outlines 3 primary criteria in terms of 1099 vs W2 debate, and these guidelines have evolved in lieu of many court cases over the decades. There is a lot of contention surrounding this issue, particularly with the COVID-19 pandemic and the fact that everybody is now working remotely.
The thing to keep in mind is how much control you exercise. If you hire an independent contractor but tell them how to work, the courts may construe it as a W2 relationship, so be careful. The following are the 3 criteria outlined by the IRS.
- Read more: How to Find Your Own (and Other’s) EINs
#1 – Degree of Behavioral Control
This is a prime item to understand when it comes to testing. With a 1099 contractor, you simply hire them for a very specific contract in order to complete a project. The more instructions you give to a worker to complete a job, the more likely they are to be looked upon as a W2. Consider the following in terms of behavioral control:
- When and where to do the work
- What tools or equipment to use
- What workers to hire or to assist with the work
- Where to purchase supplies and services
- What work must be performed by a specified individual
- What order or sequence to follow when performing the work
If you are evaluating the process of how the worker does his/her job, then it is likely an employer/employee relationship. If evaluating the completed project only, then it is likely a business/contractor relationship. Be careful not to provide detailed training to a worker if you intend to file with a 1099 form. Detailed instructions are only to be given to contractors.
#2 – Financial Control
How you pay the worker will play a large role in terms of how that worker is perceived. There are 5 primary financial areas the IRS/courts will consider. These are:
- Significant investment
- Unreimbursed expenses
- Opportunity for profit or loss
- Services available to the market
- Method of payment
Significant investment relates to whether or not the worker uses personal or business equipment. If you use personal equipment, you are more likely a contractor. However, there are often exceptions, such as workers in the construction industry who can spend thousands of dollars on equipment, and are still considered employees.
Independent contractors are unlikely to be able to claim reimbursed expenses from businesses. Often, all work-related expenses are covered only by the contractor. If there is an opportunity for profit or loss during the business or work, then it is more likely to be a business/contractor relationship. If the worker can advertise and work with many clients, it is a major indication that it is a business/contractor relationship, though not completely concrete – you can be free to advertise but still work nearly exclusively for one client with little freedom.
Finally, the method of payment is to be considered. Independent contractors are paid a flat rate for the completion of a specific job while employees get paid regardless of project completion. A fixed hourly wage that comes in weekly, bi-weekly, or monthly. Again, there are exceptions, such as the legal profession where contractors are paid hourly for project completion.
This limb is concerned with the perceived relationship between the two parties. It falls into 4 primary areas:
- Written contracts
- Employee benefits
- Permanency of the relationship
- Services provided as a key activity of the business.
Written contracts are not as important as you would think. In fact, the IRS will often ignore what a written contract says when it comes to the relationship, and examine the relationship itself. In other words, if you have a written contract with a contractor but treat them like an employee, the contract will not account for anything.
The benefits are simple. Independent contractors do not get any benefits, and employees do. Benefits can include pensions, healthcare, gym membership, insurance, paid vacation, etc. If the relationship does not have a definite end date, then the relationship is more likely to be a permanent situation between employer and employee.
Finally, if the work provided is a key activity of the business itself, then it is more likely to be an employer/employee relationship. However, this is usually only because the business will exert more control over the activity of the worker.
Why You Need to Accurately Classify Your Employees
Many business people have tried to classify their workers as independent contractors instead of employees. You don’t have to pay them benefits. And you don’t have to pay for social security and Medicaid.
Flowers Foods, a Georgia company, was sued after their drivers claimed they were cheated out of tens of millions of dollars due to being misclassified. In 2015, FedEx also had to pay $228 million due to classifying their workers as contractors. In 2013, Bowlin Group LLC, which provides installation services for Insight Communications, a cable television, telephone, and Internet service provider in Kentucky, agreed to a consent judgment in federal court to pay $1,075,000 in back wages and liquidated damages
If you are considering saving a few bucks by classifying your employees as independent contractors, think again. Misclassifying employees as independent contractors and failing to provide W2 forms can subject an employer to back taxes of as much as 41.5% of the contractor’s wages, according to the IRS. And these penalties can go back for three years.
If the IRS thinks you intentionally misclassified workers they may seek a criminal conviction with up to a year in jail and a fine as high as $500,000 for a corporation. You will also be known as a ‘tax evader’. In addition, the independent contractor themselves may be audited and will have to repay any business deductions they took during that time.
Obviously, there are many instances when you will automatically know whether or not a worker is a 1099 or a W2. Physical workers like waitresses, cashiers, receptionists, secretaries, line services representatives, etc, are all going to be W2 employees. In contrast, freelance writers, plumbers, electricians, carpenters, etc are going to be independent contractors, unless you use them exclusively for a long time and give them a fixed wage.
When To Designate a Worker As 1099
While there are exceptions to every rule, the following are the most common areas where you would tend towards classifying the workers as 1099 contractors:
- The worker uses personal resources for project completion
- The worker has control over how the project is completed.
- The worker is hired for a specific short-term project
- Worker not entitled to any benefits
- Work not paid a fixed rate, only paid on project completion
When To Designate a Worker As W2
The following are the most common attributes where you should consider classifying your workers as W2 employees:
- The worker uses business resources
- The worker follows instructions on project completion
- The worker hired for a long-time period
- The worker is entitled to benefits
- Work paid a fixed rate under all circumstances
Should You Hire W2 or 1099 Employees?
The question may arise as to whether you should use a W2 or an employee. Each class definitely has its pros and cons. A lot will depend on the type of business you are building and what you are trying to achieve. Regardless, you are always going to have some long-term employees you can rely upon. You are also going to rely extensively on freelancers for specific projects.
Remember that while it might make sense to use 1099 contractors, they do come with disadvantages. They will have other clients, and you may not get prioritized. They may not be dedicated to the business compared to a long-term employee. Finally, it takes quite a lot of time and effort to actually find a freelancer, give them a trial, and analyze their performance. Soon after, you have to find another one. It’s a lot easier to hire a long-term employee than to try and hire one 1099 contractor after another.
This point aside, you can use the following table for some loose guidance on when to hire the 1099 contractor or the W2 employee:
You have a long-term project requiring years of dedication
A W2 is the better choice. You need people to help and provide stability. It’s time-consuming to hire different contractors for various tasks
A contractor does not have the same ethos as a worker and does not care so much about long-term goals. He or she is looking only to do a specific project and not to be tied down.
You have a short or medium-term project requiring specific skills
A W2 employee is unsuitable. They are unlikely to have all the skills required for the various projects that a business will come up with.
A 1099 contractor is best here. Even the best worker will not have the range of skills needed in today’s fast-paced era. Nobody knows it all, and you have to outsource.
A W2 employee might be suitable if you have a large business. But generally, 1099 is best.
A 1099 contractor is probably best. It is cheaper and you can hire the exact skills you need, for a few hours each month.
Unless your business revolves around creating websites, then a W2 is not a fit
If you want to create a website or similar for your business, you can hire a contractor to get it done quickly and easily.
You have a series of repetitive processes
W2 workers are better here. You need to train the staff so they can do this job for the long-term. A prime example would be customer service which requires long-term W2s.
1099 contractor is not the right fit. You would be constantly hiring a different contractor for the same task.
You want to trial someone
No point in hiring somebody with a long-term work contract for a trial. There is too much red tape.
1099 is the only option. Trial them as 1099 first to give them a test run for a month or so. And hire them if they are a fit.
What Are the Alternatives to the 1099 Employee?
If you still can’t decide between the 1099 and the W2, there are two other options. The first is known as the temporary staffing agency. And the second is known as Professional Employer Organization (‘PEO’).
Generally, these are best for medium-sized businesses and some small businesses. They can help you to effortlessly adhere to Federal regulations and cut down on all administrative tasks. But they come with serious downsides as well.
The Temporary Staffing Agency
The temporary staffing agency will essentially do everything you can think of in relation to finding the right staff. This includes advertising, vetting, interviewing, hiring, payroll processing, instructions, red tape, even taxation. They do everything, and then you get a bill in the end.
Technically, the staffing agency is the employer of the staff, even though they are working on your project. As an added benefit, all staff is recorded as a single business expense on your books. You made a single payment to a single agency. Even better – you have complete control of the employee and direct them in their tasks.
So, what’s the catch? Obviously, all of this is expensive, even if it cuts down on an awful lot of red tape. Secondly, it is still hit and miss. You might get great staff, and you might get ‘ok’ staff. Either way, you still pay the temporary staffing agency the same amount. This is usually an emergency situation where businesses desperately need staff on short notice. So use it if you are stuck, otherwise, create your own process for hiring and retaining high-quality workers.
Temporary staffing agencies are a temporary solution, often in an emergency situation. PEO’s are longer-term solutions that you can use on a more permanent basis. In this instance, it is not the PEO that is the only employer of the worker. Both you and the PEO are viewed as joint employers of the workers.
You have control over the worker and can direct his/her activities. But for any HR-related duties (complaints, instructions, payment processing, benefits) the worker will go to the PEO. A written contract will stipulate the arrangement, as there are many variations.
The benefits of using the PEO are that you can offer your workers high-quality benefits at a low cost, without any bureaucracy or red tape (benefits management is an absolute nightmare for many employers, and you will want to get really good HR software to keep on top of it). The primary benefit is that the administrative tasks are taken care of. All of these workers are W2 employees of both you and the PEO.
It’s important to only use PEOs and temporary staffing agencies with superb track records. You hire them so you don’t have to deal with the HR and red tape. But if you choose a poor PEO/ temporary staffing agency, then you have made a bad problem much, much, much worse.
The Bottom Line
The 1099 worker is an independent contractor. They do as they wish, once they get the job done on time to specifications. You have little control over them and do not have to give them benefits. They are usually hired for specific projects for the short-term.
The W2 worker is an employee. They have fixed hours, fixed wages, and you exert almost complete control in terms of how they do their job. You have to give them benefits and keep the regulations in mind when working with them. They are hired for general work for the long-term.
That is all you need to know to determine whether a worker is an independent contractor or an employee unless you have a truly unusual situation.