One of the most common questions I get asked by my small business clients is, whether their workers should be classified as independent contractors (1099) or employees (W-2). I understand the reasoning. Employees are one of the most expensive cost of doing business. At first glance, it may appear that it is less expensive to classify workers as independent contractors. There are no payroll taxes, workman comp or unemployment expenses, not to mention the cost to process payroll checks and reports. However, hiring a true independent contractor may be more expensive than an employee, not to mention the severe IRS penalties for misclassifying employees.
The Contractor vs Employee Tests
As outlined by the IRS, there are three tests to determine if your workers can legally be classified as 1099 independent contractors, also commonly referred to as “subcontractor.”
- Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
- Financial: Are the business aspects of the worker’s job controlled by the payer? (these include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
- Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?
Level of Control
As I ask my clients, how much control do you have over your workers? Do you decide how much you are going to pay the worker? Do you specify the work hours? Can the worker work for competitors? Do you provide all the equipment? Do you train the worker?
If you answered “yes” to any of the above, then you have a W-2 employee. You will need to perform all the functions of a standard payroll and incur the costs.
If you wish to hire 1099 independent contractors, then you relinquish control over the worker. The worker will set the pay rate and invoice you. The worker will determine his/her hours necessary to complete the task.
As you can see, properly utilizing an independent contractor will likely be much more expensive than an employee, especially considering hourly rates, which are typically 3-4 times higher than employees. In addition, if a project is time-sensitive, you will not have strict control over the specific hours an independent contractor will work.
So, to avoid any misclassification penalties, you need to weigh the cost between hiring an employee or independent contractor. Regardless of which route you choose, be sure you file the required annual report for the worker – either a W-2 or a 1099.
If you need assistance with your worker classifications or report filings, feel free to contact us for more information.
Until next issue…Best wishes in your endeavors!