1099 or W-2: Contractor or Employee?

The thought of classifying a worker as an independent contractor is appealing to small business owners.  The main benefits of a 1099 independent contractor are that the company does not have to withhold income taxes, social security, medicare, city tax, county tax, school tax, and doesn’t pay unemployment compensation or the employer’s share of the aforementioned payroll taxes.  Instead, it is the 1099 independent contractor’s responsibility to account for his/her/its own tax liability.  The only remaining obligation on the employer is to issue a 1099-MISC form at the end of the year (if the contractor is paid more than $600/year and not a C-corp).  Although an employer has free reign to choose how to classify workers, a misclassified worker can result in severe penalties and interest to federal, state, and local agencies (i.e. the IRS).

Misclassification of a worker as 1099 independent contractor when he or she is truly an employee will result on underpayment of payroll withholding liabilities and ultimately fines and costs associated with the underpayment.  The various agencies can also impose statutory penalties in the $1,000’s for each violation.  More importantly, the fines and costs can attribute to losing your occupational permit/business license or other specialized licenses (such as the state’s refusal to renew a liquor license or a professional licenses).  Getting caught is not as hard as you think either.  As soon as a worker is terminated and files for unemployment compensation or social security benefits you will be alerted to the failure to pay the required payroll liability.  From there the violations can snowball across the various agencies.

The Independent Contractor/Employee Analysis

There is not a bright-line test to determine if a worker is an independent contractor or employee.  The general rule promulgated by the IRS is “that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done.”  In determining the degree of control an employer exerts the IRS looks at three main aspects:

  1. Behavioral:  How much control does the employer have as to “what” functions the worker performs and “how” the worker performs those functions?  The more an employer keeps the proverbial thumb over its worker the more it appears the worker is a true employee.  Factors often considered:  Employer’s level of instruction, amount of training, extent of autonomy to complete services, control of assistants, continuity of relationship between the parties, flexibility of schedule, demands of full-time work, need for on-site services, required sequence of work, and requirements for reports to be generated.
  2. Financial:  Are the business aspects of the worker’s job controller by the employer?  The factors considered here are:  Whether the worker is paid by the job or regularly,  how expenses are reimbursed, who provides tools and materials, whether worker maintains his/her own facilities, who realizes profits and losses, whether worker performs functions for more than one company, control over discharge, and right of termination.
  3. Relationship:  Are there written contracts or employee type benefits?  Will the relationship continue for a specified period of time?  The longer the relationship continues and appears like an employee/employer relationship the greater the chance the person is an employee.  But the agency will consider a written agreement between the parties as evidence of their relationship.

The best way to protect against a misclassification is by a contract that specifies the relationship between the parties with an emphasis on the factors listed above.  An independent contractor agreement provides clarity not only between the parties but also to third parties interested in the relationship, such as the IRS.  There is a delicate balance of the factors in which a knowledgeable business attorney can help with, but practically speaking a contract which sets forth factors in favor of employee status but states the worker is an independent contractor will not suffice.  At the end of the day you will have to act the part set forth in the contract, i.e. file the appropriate 1099-MISC returns and follow what is written.

If you have any questions regarding contractual issues or employee relations please feel free review the IRS standards regarding this issue or contact your attorney.