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Your business is growing in leaps and bounds and you’ve come to the conclusion that you can no longer handle it all by yourself. You need to add staff and you need to do it fast. To stay on the right side of the Internal Revenue Service (IRS), it’s important that you properly classify the new workers – ideally before they begin work. Will you classify them as 1099 contractors or W-2 employees? Proper classification is key to determining how both you and the workers will be taxed.
Both 1099 contractors and W-2 employees can provide services that are vital to growing your business. For tax and legal purposes, it’s important to note the differences between the two and classify your workers accordingly. Not doing so could land you in hot water with the IRS and subject you to hefty penalties and legal fees. You could also be sued by employees whom you wrongfully classified as independent contractors and failed to provide with benefits.
The term “1099 contractor” is derived from the form that independent contractors receive at the end of the year. The company for which the contractor worked provides the contractor with a completed Form 1099-MISC. This form contains the amount paid to the contractor during the year and is used to report income on the contractor’s tax return.
The independent contractor isn’t an employee of the company but rather a vendor — providing needed services in accordance with a written or verbal contract. Just like other vendors, the contractor may provide the services to multiple clients. Consultants and freelancers typically fall into this classification since they often offer their expertise to more than one client company at a time.
Companies may engage independent contractors for a set amount of time (per the terms of their contract) or establish an ongoing working relationship. Even if contractors work with a company for years, they’re not considered to be employees of the company if they define how and where they provide their services. In fact, some contractors may engage the services of other contractors (sub-contractors) to complete projects. If you’ve ever “hired” a contractor to remodel your home, sub-contractors (i.e. plumbers, carpenters) were likely brought onto the job to complete tasks in their areas of expertise.
Since independent contractors are self-employed business owners, they’re responsible for paying their own employee and employer (self-employment) taxes. So, if you choose to add independent contractors to your staff, you won’t have to worry about payroll taxes. Benefits that you would offer to regular W-2 employees such as health insurance, paid time off (PTO), and 401(k) matching generally aren’t offered to contractors.
All independent contractors (except corporations) that you paid more than $600 in a calendar year must receive Form 1099-MISC (Copy B) at year’s end. Form 1099-MISC (Copy A) must also be submitted to the IRS as a means of reporting the contractor’s income. To complete the year-end 1099, you’ll use information from Form W-9 which you asked the contractor to complete at the beginning of your working arrangement. This information will include the contractor’s name, business structure, and tax identification number or Social Security number.
If you don’t plan to pay a contractor more than $600 in a calendar year, the contractor doesn’t need to complete Form W-9. You also aren’t required to provide the contractor or the IRS with Form 1099-MISC at the end of the year.
W-2 employee is the default classification for workers. A W-2 employee is an employee who receives a regular salary in exchange for the services that they provide. They’re not self-employed and generally don’t define how and where they provide their services. Unless flexible or remote work is offered, W-2 employees work onsite at the company’s place of business and adhere to a set work schedule.
A company often hires W-2 employees for an undetermined length of time and provides these employees with the tools and supplies needed to perform their assigned duties. If the employee incurs business expenses, the company will typically reimburse them. This isn’t the case with independent contractors who generally provide their own supplies unless stated otherwise in their contracts.
Employers can’t pay W-2 employees less than the minimum wage (determined by federal and state laws) whereas a company can negotiate a rate with an independent contractor that’s effectively less than the minimum wage. Social Security and Medicare taxes are withheld from the employee’s pay and the company pays employer payroll taxes. Qualified W-2 employees are also allowed to participate in the company’s benefit programs and receive health insurance, contributions to retirement accounts and paid time off.
For work performed in the previous calendar year, the IRS requires employers to mail W-2 forms to all of their employees no later than January 31. Employees don’t have to receive the forms by this date, but employers must mail (postmark) forms by this date. Employees use information from the W-2 form to complete their federal, state, and local tax returns.
When comparing the two worker classifications, engaging the services of a 1099 independent contractor appears to be the best option. A business owner doesn’t have to handle payroll taxes or absorb the cost of providing benefits. Simply put, it’s easier and often less expensive. For this reason, business owners may be tempted to wrongfully classify W-2 employees as independent contractors.
If you, as a business owner, find yourself tempted to engage in this practice, consider the penalties for doing so. If you’re audited by the IRS and found guilty of wrongfully classifying a W-2 employee as an independent contractor, the penalties can be stiff. The IRS can levy fines of more than 40% of the amount paid to the “contractor”.
To distinguish between a 1099 contractor and a W-2 employee, the IRS considers the following three categories:
What the IRS is trying to determine is how much control you have over your workers. If you control the majority of the aspects of a person’s work, that person is likely a W-2 employee and you must classify him/her as such. If the worker has a considerable amount of independence in performing services for your company, he/she is most likely a 1099 independent contractor.
If you’ve considered the three categories above and still aren’t sure how to classify your staff members, the IRS can make the determination for you. File Form SS-8 to receive guidance but keep in mind that it could take months to receive the IRS’s response. It’s still a good idea to file Form SS-8 because you’ll know how to classify workers that you later hire for similar roles. Filing could also help you in the event of an audit by showing proof that you asked for guidance. This may help to eliminate or reduce penalties for misclassifying.
California-based employers that rely on the services of independent contractors have found that the California Supreme Court has made it more difficult to classify workers as such. Following the April 2018 Dynamex Operations West, Inc. v. Superior Court of Los Angeles case, a three-part “ABC” test for independent contractor status was adopted by the Court. To establish that a worker is an independent contractor and not an employee, a company must establish each of the following three factors:
Factor A is similar to the IRS’ Behavioral category for distinguishing between independent contractors and employees, so it’s in line with Federal Guidelines. To be classified as an independent contractor, a worker must have control over how and where the work is performed.
Factor B is where most California-based companies who rely on independent contractors will be hardest hit. To be classified as an independent contractor, a worker must perform work that isn’t within the scope of the company’s usual business. For example, a company that provides delivery services to local businesses will have to classify all of its delivery drivers as employees instead of independent contractors. This is necessary because the work being performed isn’t outside of the usual course of the company’s business. Companies like Uber will have to start paying benefits to their qualifying newly-classified employees and withhold payroll taxes. They’ll also have to pay employment taxes and workers’ compensation insurance. Ouch!
Factor C shouldn’t cause too much of a problem for California-based companies since independent contractors typically perform services that are in line with their skills or training. A bookkeeper that handles your invoicing is trained or experienced in bookkeeping or accounting. As long as you’re not operating an accounting firm (see Factor B) and he/she controls the aspects of the work environment (how and when work is performed), that bookkeeper should be classified as an independent contractor. What if that same bookkeeper wanted to earn extra money and drive for Uber in the evening? According to Factor C, Uber would have to classify him/her as an employee since driving for Uber is not an occupation that the bookkeeper normally engages in.
Working with independent contractors is the preference of many business owners because of the perceived time and cost savings. In this arrangement, business owners don’t have to worry about paying employment taxes, workers compensation insurance, or for benefits like health insurance and vacation time. These costs are inherent expenses when hiring W-2 employees, and can quickly add up and negatively affect the bottom line.
The lower costs associated with engaging independent contractors is a real incentive for some business owners to consider this staffing option. But, is this the best option for your particular business? Would the needs of your business be best served by hiring W-2 employees? Let’s take a look at the advantages of both staffing scenarios.
Wading through the pros and cons of 1099 contractors vs. W-2 employees may have you scratching your head in indecision. If neither seems to “check all of your boxes”, there’s another option to consider. With this option, you don’t have to directly pay benefits or payroll taxes and you get to control how, when, and where work is performed.
A temporary agency can give you access to qualified workers and, since the agency is the official employer, they handle all payroll matters and tax payments. The invoice that the temporary agency submits to your company covers the worker’s wages, taxes, and a markup for administrative services provided by the agency.
Independent contractors generally specialize in the work for which you’ve engaged them. Their rates may be higher than that of W-2 employees, but they’ll often produce work of a higher quality and you don’t have to pay benefits or payroll taxes. You only pay for the work completed.
If you’re a business owner who’s not comfortable with relinquishing control over how, where, and when work is performed, a W-2 employee may best meet your needs. If your company regularly engages in team-building activities to create a tight, family-like work environment, an independent contractor may not fit into this scenario.
After all is said and done, neither a 1099 contractor nor W-2 employee is better than the other across the board. Consider the nature of the work being performed, your budget, and the amount of control you wish to have over the work arrangement. You may find that employing the services of a temporary agency is the ideal solution to your staffing needs.
Whichever staffing option you choose, be careful to classify workers appropriately to avoid penalties.
Before making a final decision and signing any agreements, protect your business by consulting an employment attorney and/or business tax professional.
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