Should Your Small Business Hire a 1099 or W-2 Employee?
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Knowing whether to classify your workers as W-2 employees or 1099 contractors is extremely important. Misclassifications might result in an incorrect payment structure that ultimately affects how you — and your employee — pay payroll taxes.
“One of the big differences between W-2 workers and 1099 workers is the payment of employment taxes,” said Ebong Eka, CPA and president of Ericorp Consulting in Falls Church, Va. “The IRS and state tax authorities wants taxpayers, employers and employees alike, to pay their share of employment taxes like FICA, Social Security, etc.”
The IRS doesn’t take kindly to employers who improperly classify workers as employees whether they do it intentionally or not — and the consequences can be costly, so it’s best to determine a worker’s role with your business before hiring them in the first place. Review these Internal Revenue Service guidelines to ensure you understand the distinctions.
What factors to consider when classifying a worker’s status
There are three main factors to consider when determining if a worker is an employee of a business (W-2) or a contractor (1099). Answering these questions can help your business determine whether or not your worker is an employee or a contractor.
Do you need to control the worker’s behavior?
More behavioral control indicates that a worker could be an employee and less control indicates that a worker is a contractor. Ask yourself the following questions to help you decide:
- Do you dictate where, when, how and with what tools employees will complete tasks? If the answer is yes, the worker could be an employee.
- Are your instructions for tasks extremely detailed or not? Detailed instructions could indicate that the worker is an employee.
- Do you evaluate a worker based solely on results or do you also evaluate how work is completed? If you evaluate a worker’s results, he or she could be a 1099 contractor.
- Do you need to give extensive training your to workers? Extensive training could indicate W-2 employment.
Do you have financial control over the worker?
Does the worker invest in their own equipment, but use it to complete paid tasks for you and other businesses? This could indicate the worker is a contractor, not an employee. Ask yourself the following questions to make your determination:
- Does your worker routinely incur unreimbursed expenses completing work for your business? This could classify them as a 1099 contractor.
- How do you pay this worker? Hourly? Weekly? A flat rate? Employees are typically paid on an hourly or salaried basis, but contractors might receive a flat fee for work they complete.
- Does the worker provide similar services for other businesses? If they are hired out on the open market, this could mean they are a contractor.
- Does the worker have the opportunity for profit or loss? If so, they could be an independent contractor.
What is the extent of your business relationship?
Last, ask yourself the following questions about the extent of your business relationship with your worker:
- Is there a written contract in place to designate the worker as an employee or a contractor? This alone, however, doesn’t determine a worker’s classification.
- Do you offer benefits, such as health insurance, sick pay or a pension plan? Contract workers typically do not receive these benefits.
- Do you expect your worker to have a permanent or temporary relationship with you? An expectation of a more permanent working relationship could indicate that your worker is an employee.
- Does the worker handle tasks that are central to the business’s operations? If so, this could mean they should be classified as an employee.
Classifying a worker is not a subjective decision you should take lightly, according to Jim Blankenship, a certified financial planner at Blankenship Financial Planning in New Berlin, Ill.
“It’s important to get this right — because if you’re audited and you’ve had a 1099 contractor who is determined to have rightfully been a W2 employee, IRS will deem employment taxes due on the compensation from whenever the relationship began,” Blankenship said. “This can result in significant penalties for late payment of tax, on top of the tax itself.”
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What is a 1099 employee?
A “1099 employee” is a bit of a misnomer because the person isn’t actually an employee but instead a contractor. The reason a person is referred to as a 1099 is because he or she will receive a 1099 tax form reporting their wages from their “employer” around tax filing season. You must determine if a worker is 1099 status before they begin working with you — 1099 workers must fill out a W-9 form.
For employment purposes, the IRS defines a 1099 contractor as someone who has generally invested in himself or herself as a separate entity and works independently. It’s almost like they are a separate business entity you are doing business with instead of a hired employee.
For example, a 1099 contractor might have spent money for things like training and equipment to serve clients or businesses. A 1099 contractor will also have more independence when it comes to producing work. Although a business or “employer” can tell them what they need and give a deadline, a 1099 worker is typically able to work on his or her own schedule.
You do not have to remit payroll taxes to the IRS on a 1099 contractor’s behalf. They are responsible for filing their 1099 form with the IRS. As an employer, you must also submit this form to the IRS so it will have a record of earnings for the contractor you’ve hired.
What is a W-2 employee?
The IRS requires employers to report wage and salary information for employees on Form W-2. When the employment relationship begins, an employee completes a W-4 withholding form to determine the amount of payroll tax that the employer should deducted from their paycheck. By having a worker complete this form, you are recognizing that they are classified as an employee, not a 1099 contractor for your business.
An employee can work for a business on a full- or part-time basis. They might also receive additional benefits and perks, such as healthcare, a transportation stipend or an employer-sponsored retirement plan, although employers are not required to provide these benefits and they are not necessary to become classified as an employee. When you hire a W-2 employee, you’ll be responsible for remitting their portion of trust fund taxes — income, Social Security and Medicare taxes — to the Treasury.
Other staffing options
If your business isn’t in a place to hire a full-time employee, consider using temporary staffing agencies to find workers. Typically, the agency itself pays these types of workers and covers their payroll taxes. The agency will also handle any tax forms necessary for the temporary worker.
Because the employment agency is covering the tax payments and related documentation, you can expect that you will pay more— per hour or per week — for temporary workers. That said, you’d have flexibility regarding how long they would work for you. Basically, temporary workers can serve as a tradeoff between affordability and flexibility until you can cover an employee and the related costs they bring.
What type of worker should you hire?
The type of worker you should hire depends on your needs as a business and the type of business you are. For example, if you’re a manufacturer and require labor to assemble widgets, there’s a strong possibility that you’ll need employees. Because that’s an essential task for your business and you’ll probably have to train someone extensively to do it, all signs point to that person having employee status.
If you can’t afford to hire employees to keep your business going, you might need to cut back expenses elsewhere or re-examine your business model. It’s really not worth trying to avoid paying payroll taxes to “save” money when you could be heavily penalized down the road.
If you have a business that requires ancillary experts who perform specialized work without training from you, you could likely hire a 1099 contractor. If a worker is enhancing your business and performing tasks that are highly specialized, such as consulting, but perhaps isn’t central to your business’ operations, you could also hire that person as a contractor.
Determining whether a worker is an employee or not is a very serious task and should be undertaken with professional counsel. If you have doubts about a worker’s status, you can work with a labor lawyer and a certified professional accountant (CPA) to help you understand how to classify workers for your business.
Once you are sure of a worker’s proper status, be sure to have them complete forms W-4 or W-9 accordingly. If you are retroactively changing someone’s status, be sure to consult with your accountant and lawyer to update paperwork and related filings to the IRS.
Though it may seem costly, on the front end, to lay the groundwork to properly classify an employee, you will find that it’s worth avoiding the penalties, fees and interest the IRS could assess for misclassification down the line.