April 6, 2021Compliance

1099 vs W-2: What’s the difference and which worker classification should you choose

This post was written based off a webinar about W-2 vs. 1099 classification with HR expert and CEO of ModHR Sidney Bruce and tax attorney Ephraim Olson.

The 1099 vs W-2 debate has been almost continually in the news of late, as state rules change around worker classification and enforcement has increased. This has been complicated by recent legislation related to the gig economy, most notably with California’s AB5 law. Other states are following suit, and it can be hard to keep up. The difference between the two classifications are significant and if you misclassify workers, you can face penalties and, in some cases, even criminal charges.

The most important distinction to make is whether people work in an “independent contractor” capacity or if they work in a “common law employer/employee” capacity. This article will dive into the differences and what criteria is most important to look at when making a decision on how to classify your workers.

Is a worker an independent contractor or an employee?

An independent contractor is someone who works for themselves or has their own company. They are not considered an employee of the business they work with, and as such do have to pay taxes on income earned from that employer (unless a special agreement exists). The IRS defines this type worker in more detail here.

An employee is someone who works for a company and is paid on an hourly, weekly or monthly basis. They are considered to be working for the business as opposed being self-employed in their own right.

Why worker classification matters

Classifying workers correctly is important because the type of worker determines how much money is withheld from a paycheck for taxes and social security. The IRS, Department of Labor and state governments all audit for worker classification discrepancies. The difference in tax treatment (employers and employees pay more taxes than self-employed contractors) is why the IRS cares in particular.

The IRS looks to three areas to determine whether the relationship is one of an employer/employee or of independent contractor:

  • Behavioral control
  • Financial control
  • Relationship

What does behavioral control mean?

Behavioral control is the extent to which a business controls what work will be done and how it should get completed. The more behavioral restrictions, such as telling an employee when they can take breaks or where their desk must sit in relation with others’, the greater chance that this person would have been classified by IRS standards as an employee. Here are other behavioral control items that would signal someone is an employee vs. an independent contractor:

  • Instructions on when and where to work, what tools to use or where to purchase supplies and services; the more detailed the instructions, the more likely the person is an employee.
  • Evaluation systems that measure the details of how the work is done points to an employee. If an evaluation system measures just the end result of work done, it could be an independent contractor.
  • Training a worker on how to do the job—periodic or on-going training about procedures and methods—is strong evidence that the worker is an employee. Independent contractors ordinarily use their own methods.

What does financial control mean?

Financial control refers to the degree of financial risk that a company takes on when they hire an independent contractor vs. an employee. It considers if the business has the right to direct or control the financial and business aspects of the worker’s job. Here’s what to consider when looking at financial control of your workers:

  • Independent contractors are more likely to incur unreimbursed expenses than employees.
  • Opportunity for personal profit or loss is often an indicator of an independent contractor.
  • Independent contractors are generally free to seek out other business opportunities.
  • An employee is generally guaranteed a regular wage amount for an hourly, weekly or other period of time even when supplemented by a commission. However, independent contractors are most often paid for the job by a flat fee.

The relationship between the worker and employer

The type of relationship depends upon how the worker and business perceive their interaction with one another. This includes:

  • Written contracts, which describe the relationship the parties intend to create; although a contract stating the worker is an employee or an independent contractor is not sufficient to determine the worker’s status.
  • Businesses providing employee-type benefits, such as insurance, a pension plan, vacation pay or sick pay, have employees. Businesses generally do not grant these benefits to independent contractors.
  • The permanency of the relationship is important. An expectation that the relationship will continue indefinitely, rather than for a specific project or period, is generally seen as evidence that the intent was to create an employer-employee relationship.
  • The extent to which services performed by the worker are seen as a key aspect of the regular business of the company can impact status.

The Department of Labor’s qualifications

The Department of Labor (DOL) also looks to determine whether a relationship is employer/employee or contractor.

The DOL is responsible for enforcing labor rights under federal laws like the Fair Labors Standards Act (FLSA). There are several laws that apply to employees that do not apply to contractors. For example, employers must follow minimum wage and overtime laws. 

To better understand how the DOL determines worker classifications, consider the case Crouch v. Guardian Angel Nursing, Inc. As part of that case, nurses who worked for a staffing agency were found to be employees and not contractors based on the following:

  • The permanency of the relationship between the parties
  • The degree of skill required for the rendering of the services
  • The extent of the worker’s investment in equipment or materials for the task
  • The degree of the alleged employer’s right to control the manner in which the work is performed
  • Whether the service rendered is an integral part of the alleged employer’s business

States also care about worker classification

Every state has different laws related to worker classification, and states often care deeply whether workers are correctly classified. Several states have agreements with DOL to share information collected during audits at either the state or DOL level, so both parties can catch and stop infractions.

Why do States care?

  • States give unemployment insurance to employees but not contractors
  • States give workers compensation benefits to employees but not contractors
  • States have a vested interest to ensure that injured or out-of-work individuals can participate in the safety programs rather than rely on the state for aid

Penalties for misclassifying employees workers

Employers who misclassify employees as contractors are subject to fines and penalties. The IRS penalty for misclassifying employees as contractors can equal 20% of the wages paid; 100% of the employee FICA taxes that should have been withheld; 100% of the employer FICA taxes that should have been withheld; 20-75% of the underpayment of taxes; 25% of the late payment of taxes; and a per-worker fine.

The DOL penalty for misclassifying employees as contractors can equal any overtime that should have been paid (1.5X normal wages for any hours over 40 worked in a week). Plus, courts can award an additional 100% of unpaid overtime payments.

Penalties can also include severe criminal sanctions, including felony charges. 

Conclusion: Why incorrectly classifying workers is not worth the risk

The penalties for misclassifying employees as contractors are severe, including in some instances felony charges, which should be enough to deter most employers from making this mistake. Since there are legal ramifications to the decision, it can be a good idea to consult an attorney. An attorney can help you determine if the worker is an employee or contractor based on their duties and responsibilities. Consulting with legal counsel will also provide some peace of mind that you’ve made all appropriate determinations before proceeding down one path over another.

Still not sure how to classify your workers? Watch our on-demand webinar about W-2 vs. 1099 classification with HR expert and CEO of ModHR Sidney Bruce and tax attorney Ephraim Olson.