When you hire an employee to work for you, you can either pay them as a contractor or as an employee. A shorthand way to consider this employment relationship is 1099 vs. W2 employees, because contractors receive the 1099 tax form at the end of each year, while employees receive a W2 form.
But, it's not just about the tax form. And it's not a choice that you get to make based on business needs. You have legal obligations to qualify a person as either a contractor or an employee. Here is what you need to know.
1099 vs. W2 Employees
An employee receives pay for working for you or your company, and as the employer, you must withhold taxes and pay their portion of social security. If you terminate the employee, they are often eligible for unemployment benefits. If they meet the other requirements, they are eligible for benefits such as health insurance, worker's compensation, FMLA, and ADA protection.
Contractors, on the other hand, work for themselves. Independent contractors pay all of their own taxes, and there is zero withholding from their paycheck. They can also work for multiple employers. The downside is that they are neither eligible for benefits nor FMLA or ADA protection. However, according to the New York State Department of Labor, an independent contractor may be eligible for unemployment insurance.
As you can see, if you offer an employee and a contractor both $15 an hour, the actual cost to your business is much higher than $15 an hour for employees. For this reason, companies may prefer to pay a person as a contractor. However, a smart contractor may charge a higher rate to compensate for the benefits and taxes they must pay themselves.
You cannot just decide whether someone should be an employee or a contractor. The choice of classification must meet strict guidelines.
What Makes a Person a Contractor?
When you hire people to work for you, you should assume they are employees (W2) unless you can prove that they are contractors (1099). The Department of Labor released an opinion letter in April 2019 to help companies determine whether a person should be hired as a contractor or an employee. They provide a six-factor test that comes from the Supreme Court.
When deciding between a 1099 contractor and a W2 employee, consider the following:
- The nature and degree of the employer's control
- The permanency of the worker's relationship with the employer
- The amount the worker invested in facilities, equipment, or helpers
- The amount of skill, initiative, judgment, or foresight required for the worker's services
- The worker's opportunities for profit or loss
- The extent of integrating the worker's services into the employer's business
You must consider each one of these factors when you decide on how to classify an employee you hire.
What Are IRS Guidelines for Classifying a Person as a Contractor?
The IRS also has guidelines for classifying a person as a contractor.
- Behavioral control: A worker is an employee when the company has the right to control the work performed by the worker. Otherwise, they will most likely classify as a contractor.
- Financial control: If you’re an employee, the business will have a right to control the financial and business aspects of your job. If you’re a contractor, you may have more power.
- Relationship: The type of relationship depends upon how the worker and business perceive their interaction with one another. This can be gleaned from a written contract, a benefits package, and a sense of permanency with the role.
What Are the Consequences for Misclassifying a Person?
If you classify a worker as a contractor and the Department of Labor or IRS later determines that you misclassified the person, the penalties you incur can vary on a case-by-case, state-to-state basis from monetary fines to even criminal punishment.
The Bottom Line
If you pay a person who doesn't meet the guidelines described above, that person is an employee. Fill out the correct paperwork, withhold taxes, pay your taxes correctly, and give them any benefits they are entitled to receive them.
While employers may try to save money by classifying a person as an independent contractor, it's not always worth the legal risk of misclassification. If you're concerned, double-check with your employment attorney before categorizing someone as a contractor.
Please note that the information provided, while authoritative, is not guaranteed for accuracy and legality. The site is read by a world-wide audience and employment laws and regulations vary from state to state and country to country. Please seek legal assistance, or assistance from State, Federal, or International governmental resources, to make certain your legal interpretation and decisions are correct for your location. This information is for guidance, ideas, and assistance.