Are your contractors employees or 1099 contractors?
Contractors need to know that simply signing an independent contractor agreement with a worker or sending them a Form-1099 does not mean that the IRS will agree. The IRS may decide that the individual classified by your business as an independent contractor is actually a W-2 employee.
IRS consequences for employee misclassification are severe and may include fees and fines for the employer, financial damages paid to the employee, and criminal charges. Protect your contracting business from the consequences of misclassifying an employee as a 1099 contractor by learning what the IRS employee classification factors are.
Here is what you should know about how the IRS classifies employees versus 1099 contractors and how to avoid the severe risks of 1099 contractor misclassification.
What is a 1099 Contractor?
An independent contractor is a self-employed worker, according to the Internal Revenue Service (IRS). Whether a worker is an independent contractor depends on the specific facts in each case. Generally, an individual is considered by the IRS to be an independent contractor if the payer only has the right to control or direct the result of the work, but not when or how it is done.
Some examples of individuals who are typically considered independent contractors include doctors, veterinarians, dentists, lawyers, accountants, subcontractors, contractors, or auctioneers in an independent business.
However, for your contracting business, each worker’s status as an independent contractor may vary.
What is a W-2 Employee?
An employee, or common-law employee according to the IRS, is an individual who performs services for you where you can control what work and how the work will be done. What matters to the IRS is that you control the details of how the services are performed.
A W-2 employee is economically dependent on an employer, while an independent contractor is in business for themselves. Employees also have specific rights under the FLSA, FMLA, and MSPA that independent contractors do not have.
The differences in the rights of a 1099 contractor versus an employee include for employees:
- The right to be paid at least minimum wage and pay for overtime
- The right to job-protected, unpaid family and medical leave
- Protection under anti-discrimination and anti-retaliation laws
- Access to workers’ compensation if injured on the job
- Access to unemployment insurance
- The employer pays half of the Social Security and Medicare taxes
It is important to note that the IRS does not consider whether an employee is on the payroll or not to make this determination. Furthermore, it does not matter if the independent contractor has an EIN or paperwork that states that the independent contractor is an LLC or some other business entity. The IRS may still consider the individual as an employee in its determination.
W-2 Employee vs. 1099 Contractor? Independent Contractor Misclassification Risks
IRS penalties are substantial for businesses that misclassify their workers as 1099 contractors instead of W-2 employees. A business found to have misclassified its workers may find itself responsible for paying out all the taxes and benefits related to the worker’s actual status as a W-2 employee instead of as an independent contractor.
IRC §3509 details the penalties for employee misclassification, which include the employer being responsible for:
- Portions with interest of each misclassified employee’s owed wages, including overtime, minimum wage, and paid time off.
- Pro rata shares of Social Security and Medicare tax contributions
- Unfiled W-2 forms, including the income tax withholdings and payroll taxes
- Assessments that are equal to the employer’s matching contribution for employee benefits, including 401(k) contributions, healthcare coverage, workers’ compensation, disability insurance, and more
An employer may also face criminal penalties, including prison, in cases of intentional employee misclassification. In other cases, the IRS may offer the option for the employer to pay the penalties through their IRS Classification Settlement Program (CSP). Talk with an accountant to find out what your options are if you are facing an inquiry from the IRS regarding employment misclassification.
What Are the Common Law Rules That Determine How Much Independence a Worker Has?
The factors that determine whether the IRS classifies an individual as a W-2 employee or independent contract are behavioral, financial, and dependent on the type of relationship.
There are 20 factors that the IRS uses to test if an independent contractor is a W-2 employee or not. These are the 20 factors the IRS uses to classify full-time employees vs. 1099 contractors:
- Level of instruction
- Training required
- Degree of integration with the business
- Extent of the personal services provided to the employee
- Control over assistants
- Ongoing, continuous relationship with the employer
- Flexibility of schedule
- Employer demands full-time work
- Work is performed on-site
- Work is performed in a specific sequence
- Reporting requirements
- Payment method
- Payment of business or travel expenses
- Company-provided tools and materials
- Reliance on the employer’s facilities
- Realization of profit or loss
- Working for multiple companies simultaneously
- Worker’s services are available to the public
- Control over the ability to terminate the relationship
- Whether the worker can terminate the work agreement without liability
If you’re unsure whether an individual working for you in your contracting business is an employee or 1099 contractor, you can file IRS Form SS-8, and the IRS can make the determination for you. If you make the determination on your own, there is still a risk that the IRS could disagree.
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