How to Classify 1099 Workers vs W-2, & Why You Can’t Mess Up

If you’ve been at all privy to the drama in the California worker classification roller coaster of the last couple years, you know that determining employee vs. non-employee status has been a huge, controversial legal debate.

Controversial and money-sucking — hundreds of millions of dollars have been spent on this issue, and there is more state legislation percolating in Illinois, Massachusetts, and New York. President Biden even put worker classification as one of his policy concerns on his campaign website.

So we’ve established that worker classification is… a big thing.

As a small business owner, you don’t have an HR team. You don’t have a pack of lawyers, or a dedicated department for payroll administration. The challenges of hiring, onboarding, and determining employee status fall right on your overworked shoulders, and messing up is expensive.

…lucky you.

So if you’re well aware that determining the correct classification for 1099 vs. W-2 workers is important, but aren’t sure about the precise federal definitions, we’ve got you covered. We’ll also illustrate how to determine which status is better for various small business purposes. Lastly, we’ll emphasize why you really can’t mess this one up.

Measure twice, cut once. Or… maybe leave that to an independent construction contractor. Your call.

What’s the difference between 1099 and W-2 workers?

1099 and W-2 refer to the tax forms that you’ll distribute to workers during tax season. 1099-NEC forms (which we wrote about last week) are given to non-employees and W-2 forms are given to employees. So the real question becomes…

What is the difference between an employee and non-employee?

Seems obvious on the surface, right? An employee probably works more hours than a non-employee. You get a cake for an employee’s birthday. Buy chocolate for an employee’s son’s soccer team fundraiser.

A non-employee or independent contractor is… independent, right? A contractor. Works sporadically. You definitely don’t see them every day.

That may be true, but the IRS is not quite so casual.

So how do you determine correct classification?

Unfortunately, the IRS doesn’t make it crystal clear either. As their website explains, the determination hinges on a few factors.

• Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
• Financial: Are the business aspects of the worker’s job controlled by the payer?
• Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?

Goodness.

Another, more vague, but perhaps simpler rule states: “an individual is an independent contractor if you, the person for whom the services are performed, have the right to control or direct only the result of the work and not the means and methods of accomplishing the result.”

Basically, you get to tell employees how, when, and where to accomplish their work. The “how” might be, in this manner, because this is the way we conduct our core business. The “when” is likely a consistent number of hours per week, at set times. Then the “where” is probably at your store or office.

Independent contractors, on the other hand, only owe you a product or a service by a deadline. Their services may be unrelated to your core business, and while the where and when might be set — for example, someone coming in to repaint your office — you won’t tell them how to paint, or what tools to use.

What are my obligations to an employee vs. non-employee?

Now you’re asking the real questions.

Employees are paid a wage, and receive employee benefits. You will withhold and pay income, social security, unemployment, and Medicare taxes on their wages.

This is not true for independent contractors, who will pay their own self-employment taxes.

Keep this in mind. It’s all about the money.

For which type of work will I use employee vs. non-employee labor?

This one can vary depending on your industry and business model.

Classically, small businesses tend to use independent contractors for business-adjacent services. This can include accountants, lawyers, contractors for any building improvements or renovations, web designers, landscapers, or freelance consulting services.

And there are definite benefits to using independent contractors for the right type of work. First off: you’ll save money. Independent contractors tend to be less expensive than hiring someone as a regular employee, because you do not have to provide them with a workspace, or pay for their taxes and benefits.

Independent contractors may also be valuable for the strategic scaling of your business, or for a particular project that needs a specific skill set.

What happens if I misclassify a worker?

First off — don’t. It’s expensive.

Misclassifying can lead to several unpleasant outcomes. First of all, if it is determined that an independent contractor should actually have been hired as an employee, you’ll be on the hook for all of their unpaid employment taxes.

Even less pleasant — a misclassified worker can sue you for any missed benefits and overtime. While you don’t want to be liable for missed tax liabilities, you definitely don’t want to be wasting money on attorney fees and penalties, and time on headache-inducing meetings with your state labor board.

If you misclassify the other way around, it’s slightly less risky, but still expensive. After all, you’ve likely paid Social Security and Medicare taxes on wages that you didn’t need to.

What if I’m unsure?

As a one-person HR department, it’s understandable that you don’t want to make expensive mistakes. That’s why it’s smart to consult with a (non-employee) lawyer if you’re ever unsure.

And if you need help when cranking out all those 1099’s and W-2 forms during tax season, be sure to contact Know Your Numbers Accounting for helpful, speedy service.

Do you tend to hire more employees or independent contractors? What do you find are the pros and cons of each? Let us know below.