Independent Contractor? W2 Employee? How to know the difference and why its important!
“Hiring” an independent contractor instead of a W2 employee, has been a popular way for employers to access important expertise without having to hire or develop it.
But blurring the difference between an independent contractor and a W2 employee can put you at serious risk for a misclassification audit!
The US Bureau of Labor Statistics estimates that anywhere between 6.9% and 9.6% of the total workforce are “independent contractors” . That’s 10 – 15 million workers.
Unfortunately, the legal and financial ramifications of more 1099 workers has not escaped the scrutiny of the IRS, the DOL, and a variety of state agencies. These are agencies who don’t always view the relationship between employer and worker as all that “independent and are on the look out for employers who are not compliant.
Worker misclassification issues continue to bubble up for Northwest employers as the IRS and DOL uncovers situations where the lines between employee and independent contractor get blurred and workers are financially impacted. The IRS and the DOL have successfully collaborated to collect billions of dollars in back taxes and penalties stemming from worker misclassifications charged against large and small employers alike.
If you ask your “independent contractor” to act, talk, and walk like an employee even though you are classifying and paying them as a 1099 vendor, you are taking some serious risks.
Why does the IRS and DOL care?
The IRS cares because of of the impact to tax revenues when an employee is misclassified as a 1099 worker. When an employer hires a W2 employee, the social security and medicare taxes are a liability shared between the employer and employee. Each pays 7.65% of the employee’s wages to cover these taxes plus an additional 3-5% of the employee’s wages to fund state and federal unemployment benefits and workers compensation.
An independent contractor, on the other hand, is responsible for what is called a “self employment” tax. While the two taxes are similar in $$$ value, they are very different in those taxes are calculated and paid. The employee has their tax liability automatically withheld from their paycheck. A self employment tax is paid quarterly.
The DOL cares because an independent contractor arrangement sometimes is used to avoid state wage and hour laws including overtime and/or minimum pay requirements. The highly publicized dispute with UBER over how they classify their drivers developed around the claim that by considering their workers “independent” they were avoiding FLSA overtime pay requirements.
And here’s the rub……..if you classify a worker as an independent contractor when in act you are treating them as an employee, you are likely to be held liable for the payroll taxes that would otherwise have been paid had the worker been classified correctly at the point of hire. You could also be responsible for pay increases, overtime pay and retroactive benefit costs if you are cited for being out of compliance with state minimum wage or federal FLSA standards.
What are the legitimate reasons why employers might want to classify a worker as an independent contractor?
In most of the situations we get involved with, the worker themselves will dictate the classification decision. Many highly talented workers with the skills and experience the employer needs are only willing to to to work for an employer willing to classify them as a 1099 worker.
The rationale for using a 1099 worker often makes business sense.
- The worker can be onboarded quickly – without going thru the rigors of creating a structured job description or placing limits on rate of pay.
- The worker becomes a variable rather than a fixed cost. They are only paid for work performed, which can be flexed up or down depending on business need. Committments can be up or downsized without notice. These are features that appeal to employers who rely on these forms of flexibility to optimize profitability.
- The worker comes independent of costly benefit packages and accompanying administrative requirements. The employee is paid outside a compliance sensitive payroll system based on the submittal of an invoice to accounts payable.
- Most 1099 workers come on board ready to contribute – with no hidden training or development costs
Convenience and flexibility aside, employers are attracted to independent contractors because they typically bring a special level of skills, expertise, and savvy to the table not always available in the employer’s core employee group.
Why do certain workers prefer to work as “independent contractors”?
We’ve found 3 main reasons why certain highly skilled employees prefer independent contractor status:
- They get exposure to a wider range of technical or professional challenges than are typically available to them working for only one employer . At a certain stage in an employee’s career, those types of challenges have special appeal.
- They prefer the flexibility they get by being able to work (or not work) when they want….a benefit not always available to them when in a core role.
- They can earn a higher level of pay based on supply and demand for the expertise they bring to the table. They also are able to deduct more work related expenses than they could as an employee. .
What are the defining differences between an independent contractor and a W2 employee?
Theoretically, a 1099 and a W2 employee are two very different types of workers in terms of when and how their contribution to a company is delivered, how their work is performed, who and how it is supervised, and ultimately who is accountable for the quality of the work product. Bottomline an employee works under the “control” of their employer, and is paid via a payroll system. An independent contractor works under their own control and is paid by invoice.
How do you decide?
Unfortunately, the “tests” for true 1099 status are not always as straight forward as an employer might like leading to many misconceptions about the underpinnings of the classification process.
One of the common misperceptions is that an “contractor” can be considered legally independent if they can satisfy the legal requirements of a contractor – the proper business licenses, FEIN and UBI (tax ID numbers), Workers Compensation insurance, etc..
Taxing agencies, on the other hand, see the claim for independence differently – based not on the employee’s legal status but on the level of control the employer has over the work performed during the agreement period.
Depending on who is doing the auditing, there are three areas of control that typically get reviewed:
- Behavioral Control – to what degree does the employer direct the worker’s day to day behavior. The more control an employer has over where, when, and how work is performed, the less likely the worker can be considered “independent.”
Employers who require an independent contractor to work in accordance with a specific work schedule, or specify the number of hours to be worked in any day, week or month – when, where and how – put their classification as an independent contractor at risk.
- Financial Control – how much of an independent contractor’s total income comes from you? The more control an employer has over a worker’s primary source of income, the less likely that worker is considered “independent.” An agreement to pay an independent contractor a fixed $$$ amount each week might trigger concern if tied to an assumption of a 30-40 hour week. An agreement to pay the worker an hourly rate IF the agreement includes a provision that your independent contractor work 40 hours/week would also be of concern. Agreements that tie a worker to a particular employer as a (primary) source of income, tend to make their “independence” suspect.
Other considerations related to “financial control” include payments or reimbursements for business expenses, equipment or tools. For the most part employers want to minimize reimbursement agreements to avoid the appearance of exerting control over what should be considered the contractor’s business costs.
- The Business Relationship – the length, exclusivity of the independent contractors relationship with your company and the type of work performed. Case law seems to point to the fact that work assignments intended to last six months or longer get looked at more closely than do shorter term work assignments. Its clearly important that the worker be free to pursue other business opportunities. They need to be paid via an invoice not thru a payroll system.
NOTE: Companies who regularly entertain independent contractors who work 40 hr/week for years at a time, are likely going to be seen as stretching the definitions of “independent” when put under audit review.
Another consideration is the nature of the work performed. If it is integral to the performance of your business, it might be difficult to consider it independent. (ex. an attorney working in a law firm, with their work being considered the product of the firm, might not be able convince an auditor that they are “independent”.)
Never good. The IRS estimates that businesses misclassify W2 workers as 1099’s as much as 60% of the time which makes misclassification audits commonplace. If a misclassification is uncovered, the outcome can be serious—back taxes, fines, and penalties in addition to costly law suits stemming from unprotected workplace accidents or injuries.
What are some of the conditions that might trigger a misclassification audit?
There are several scenarios that the IRS and the DOL consider suspect…..
- Overlapping a W2 and 1099 status for the same employee in the same report year can be an audit trigger.
TIP: Avoid firing a W2 worker and bringing them back as a 1099.
- There is a form, IRS SS-8’s, which employers can use to request an official determination of a particular worker’s classification status.
TIP: Keep the number of SS-8 filings to a minimum.
- Most (70% to be exact) of misclassification audits get triggered by workers classified as 1099s who who file for benefits that are only available for W2 workers. For example if an employee files an injury report or claims reimbursement for medical costs associated with a workplace injury, or files a claim for unemployment, the IRS is likely to notice.
TIP: Make sure your independent contractor knows they are not eligible to file a claim citing you as their employer.
What can companies do to protect themselves from misclassification issues?
The best answer is also the simplest—make sure your independent contractors are really independent – meaning they are working in ways as free as possible from your control.
When you’ve determined their independent enough to be brought on as a vendor not an employee, make sure you follow some 1099 best practices.
If the level of independence you need to support your decision to treat them as a 1099 isn’t possible, your choices are to…
1) End your relationship with the 1099. Not a great solution.
2) Convert the 1099 to your W2 workforce by hiring them directly – not always possible when there are policies in place that limit your ability to add employee headcount.
3) Use a third party Employer of Record service provider to hire your 1099 worker on your behalf and then re assign them to work for you under conditions that you control. (We’ll talk more about this option later)
What are Employer of Record services? How do they help with misclassification issues?
Because the issues surrounding employee classifications are not always white/black, one of the ways to avoid the unforeseen costs of a misclassification audit is to actually prohibit the use of personal service 1099’s in your organization, and require them to onboard an independent contractor using an Employer of Record service provider who assumes the “employer role”. This is a strategy that ensures that all “independent contractors” have a bonafide employer, eliminating the risks of misclassification, while allowing the employer to exert as much or as little control over the employee’s work as needed.
The Employer of Record service provider handles all the paperwork relative to the hire, ensures worker compliance with the terms of the agreement, and will typically offer weekly pay. The service fees are typically calculated as a small mark up over direct costs.
As an incentive for your worker to become an employee, they get to eliminate all requirements to calculate and pay self employment tax and yet can maintain any level of flexibility that is acceptable to you. In most cases their “take home pay” either goes up or remains the same.
What type of companies provide Employer of Record services?
Many staffing agencies, like PACE Staffing Network, are willing to payroll a worker a client brings to them for re assignment to their work group. True employer of record services includes payroll services and more which not all staffing companies provide.
When inquiring about Employer of Record services we recommend you inquire about the scope of services being offered by your service provider. They should include systems and procedures to quickly on board a formerly 1099 worker to the policies of your workplace plus orient them to the world of W2 employment. They should be organized to provide hands on support for your worker throughout the duration of their “work assignment”. Your worker should be offered a full menu of benefit options, plus eligibility for state mandated benefits. Pay plans are organized to include automated time collection.
For more information on how an Employer of Record service can be custom designed for your unique needs, contact our Partner Services and Solutions team at 425-637-3312.
PACE Staffing Network is one of the Puget Sound’s premier staffing /recruiting agencies and has been helping Northwest employers find and hire employees based on the “right fit” for over 40 years.
A 4 time winner of the coveted “Best in Staffing” designation , PACE is ranked in the top 2% of staffing agencies nationwide based on annual surveys of customer satisfaction.
PACE services include temporary and contract staffing, temp to hire auditions, direct hire professional recruiting services, Employer of Record (payroll) services, and a large menu of candidate assessment services our clients can purchase a la carte.
To learn more about how partnering with PACE will make a difference to how you find and hire employees, contact our Partner Services and Solutions team at 425-637-3312, e mail us at firstname.lastname@example.org or visit our website at www. pacestaffing.com/employers.