In recent years, there has been an increase in the number of businesses classifying workers as independent contractors rather than employees. While there are several differences between these two types of workers, the biggest (and most important to you as an employer) is the requirement to deduct the various payroll taxes from each W-2 employee’s paycheck, while 1099 independent contractors are responsible for filing and handling all their taxes on their own.
The second, related difference is which tax form is used to report a worker’s income to the IRS. Employees are sometimes referred to as “W-2 employees” because they receive IRS Form W-2 from you. Contractors, on the other hand, should receive Form 1099 to report their earnings.
While businesses typically handle worker classification internally, the IRS can sometimes step in to make the final determination as to whether the person you just hired is really an independent contractor, or whether they should be on the payroll. Here’s a quick cheat sheet for telling the difference so you can classify your staffers correctly:
Generally, a worker should be classified as an employee if:
On the other hand, a worker is likely to be considered an independent contractor if:
Let’s look at a couple of examples. Let’s say John is hired to provide social media support to a business, but he is required to use a company computer, report to work at a certain time, and complete work in a specific manner. In this case, John should be classified as an employee. However, if John is hired to provide social media support to a company and he handles this work using his own equipment, on his schedule, and works with other small businesses to offer the same services, John should be classified as an independent contractor.
The correct classification is essential, particularly since businesses are required to withhold and pay federal and state taxes, Social Security and Medicare, and unemployment taxes for each employee, while no taxes are withheld or paid for independent contractors. This is why the IRS looks very carefully at how a worker is classified.
If you’re still uncertain, Form SS-8 can be filled out and submitted to the IRS. This form asks the IRS to make a determination on how your worker should be classified and whether you should file a W-2 or 1099. It can also be used by workers who believe they should be classified differently.
The IRS doesn’t fool around when it comes to classification (or much else), so there could be a penalty involved if they determine that workers have been misclassified — accidentally or not. This penalty can include holding the business liable for any and all employment taxes for the worker(s) in question.
However, the IRS currently offers a voluntary classification settlement program for business owners who agree to 1) reclassify their workers for future tax periods, and 2) agree to pay 25 percent of the employment tax liability for the most recent tax year.
The employee vs. contractor question also has an impact on some of the paperwork you’ll need to take care of. When hired, independent contractors must complete Form W-9 which should be kept on file for four years. If a worker is classified instead as an employee, they need to fill out Form W-4 to determine the level of federal tax that should be withheld from their paycheck. W-4s should also be kept on file for four years after the date the employment tax becomes due or is paid (whichever is later). Remember, you’ll also need to collect withholding forms if you collect state and local taxes.
At the end of the year, there’s also a difference in the tax documentation you send to employees and independent contractors. As mentioned previously, contractors should receive a copy of Form 1099-NEC, while employees will receive Form W-2.
If you would like additional information on classifying workers, please visit the IRS website, which provides an entire section on independent contractors and employees. Or talk to a tax or HR advisor to get more information. Getting those W-2s and 1099s right will save you a lot of time and potential liability down the road.