If you have people (employees or contractors) working for your business, it’s important to classify them appropriately. Why? Because if you pay someone on a 1099 as a contractor, and it turns out they should’ve been paid on a W-2, your business can find itself in hot water.
What’s the difference between employees and contractors?
The way you classify your workers determines whether you pay employment tax and withhold other taxes from their pay.
- For employees paid on a W-2, the business withholds income taxes and pays social security, medicare, and unemployment on all wages.
- For independent contractors, the business doesn’t withhold or pay any taxes—all pay goes directly to the contractor, who is responsible for paying the taxes.
How do I know if my workers are employees or contractors?
The answer essentially comes down to the business’s level of control over the worker. Generally, businesses have more control over employees and less control over contractors. The IRS provides three categories of control to help you identify the appropriate classification:
1. Behavioral control
- Employees: The business controls when and where the work is done, gives detailed instructions on how the work should be completed, provides training, and evaluates the details of work done by employees.
- Contractors: Make their own schedules, choose where and how to complete the work, and are generally evaluated on results as opposed to details of how the work is done.
2. Financial control
- Employees: The business has a significant investment in the equipment employees use to complete their work and covers necessary expenses.
- Contractors: Pay for their own equipment and business expenses and will typically have an opportunity for profit or loss. Independent contractors are also free to work for multiple businesses at one time.
3. Relationship
If the business provides benefits, those are available to employees and not contractors. The relationship between the business and employee is seen as indefinite, while a contractor may be hired for a fixed period or be performing services that aren’t key business activities.
The January 6, 2021, update to the Fair Labor Standards Act clarified the rules concerning employees vs contractors, effective March 8, 2021. The new ruling provides more specifics related to the three tests described above, but the essence of the definitions remains the same.
Let’s look at some examples to see how those arrangements play out in real businesses.
Example 1: June is a graphic designer. She works remotely for a marketing firm, creating advertisements and graphics for client websites. The firm purchased her computer and all software licenses she needs to do her job; June pays for her own internet and phone. She signed a non-compete agreement that bars her from working for any other agencies.
Answer: June is an employee. Although she works remotely, she’s dedicated to the marketing firm, and they pay for most of the tools and equipment she needs to do her job.
Example 2: Michael is a full-time student, and he also works for a logistics company doing last-mile deliveries. He uses his own vehicle, but the company reimburses him for mileage and provides liability insurance coverage. The company allows Michael to work around his class schedule, but he works the same hours every week. He receives two weeks of paid vacation each year.
Answer: Michael is an employee. Although he uses his own vehicle for work, the company pays his expenses via the mileage reimbursement and provides the benefit of vacation time. The set work schedule (although it’s flexible) is another indicator that Michael is an employee.
Example 3: Selena is a part-time pet sitter with a start-up that provides local pet care services. Each week, she logs into the app and selects from a list of jobs posted by clients. The company collects payment from clients and pays Selena the agreed-upon fee. Her fees increase as clients give her good ratings in the app.
Answer: Selena is a contractor. She sets her own schedule and workload, and she’s evaluated based on client satisfaction with her work. She’s also free to take on other work if she wishes to do so.
What’s the difference between a W-2 and 1099 form?
Annually, in January employers file a W-2 form to the IRS on behalf of their payroll staff. Companies that pay contractors must issue a Form 1099 to non-payroll workers paid more than $600 for services during the year. Both these forms indicate the amount of money earned from the company within the given year. For W-2 employees, it also includes employer-withheld taxes.
The IRS can hold you liable for all employment taxes if you’ve incorrectly classified workers as contractors. For more on this topic, visit the IRS website.
When must businesses file a 1099 form?
Section 6041 of the Internal Revenue Code requires businesses to file a 1099 form if they paid a nonemployee or contractor at least $600 during the year, provided the payment had a business purpose. Starting in the 2022 tax year, new reporting requirements for third-party payment settlement networks, such as PayPal and Venmo, apply. Anyone who is paid over $600 during the year for services (regardless of the number of transactions) will receive Form 1099-K. This is a significant change from previous years, in which the form was only sent to nonemployees who received over $20,000 in gross payments AND took part in more than 200 transactions.
Update: Congress has delayed the law requiring e-commerce platforms to report information on workers earning $600 or more, which was a part of The American Rescue Plan Act of 2021. This law has been pushed by one year, meaning platforms such as Airbnb, eBay, and Etsy will rely on the threshold of more than 200 transactions worth an aggregate above $20,000 for 2022 (not $600).
Contractors, here’s what to do when you receive an incorrect 1099.
Classify your workers correctly from the start
If you’re starting a new business or taking on new staff and unsure whether your workers should be contractors or employees, let us help you make the correct designation. Schedule your consultation.
