Employee versus Independent Contractor Compliance
What’s the difference between W2 employees and 1099 workers?
Employee versus independent contractor. Reports have shown that 10-20% of independent contractors are misclassified. Do you know how to tell if you’ve hired a W2 employee or a 1099 independent contractor?
It is advantageous to hire independent contractors, but not if they are misclassified. Hiring independent contractors / freelancers increase flexibility and reduce labor expenses (i.e., training and tax costs). However, it is important to ensure that you (as an employer) properly classify workers to avoid liabilities and penalties due to violations of tax laws.
Agreeing with the worker on an independent contractor status without a reasonable basis does not safeguard against being held legally liable for misclassification.
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How to tell if someone is an employee versus an independent contractor?
Before you discover halfway through the working relationship that you have misclassified a worker, let’s discuss the behavioral, financial, and relationship control factors that determine whether you are actually hiring an employee or an independent contractor.
What behavioral control do you exert on your workers and their work performance?
Work Hours, Location, Tools, and Equipment. An employer does not control an independent contractor’s schedule of work hours nor does an employer dictate where a freelancer must do their work. Moreover, an employer does not provide or specify the equipment and tools that a freelancer uses. In fact, a freelancer’s investment in their own tools and equipment helps support independent contractor status.
Service Offerings and Training. A freelancer usually offers services to the general public and usually offers specialized skills and abilities (often with certifications/licenses obtained from training programs). In contrast, an employee is often offered training from his or her employer.
Reporting and Sequence of Work. There are many other aspects of behavioral to consider. If you require your worker to provide frequent reports of his or her work activities, that may indicate a lack of independence and undermine independent contractor status. Similarly, controlling the sequence of work to be completed also undermines independent contractor status.
Meetings. Even requiring workers to attend meetings undermines independent contractor status and implies an employee relationship.
Assistants and Delegation. Also, independent contractors can generally hire or engage their own staff, assistants, or other workers and pay them directly. Restricting a worker to delivering the services personally and preventing them from delegating to others often indicates an employee relationship.
Contract and Scope of Work versus Handbook, policy and procedures, and job descriptions. In addition, an independent contractor usually receives a contract that includes a scope of work, while an employee usually receives a handbook, policy and procedures, and a job description. And an independent contractor is solely evaluated on his/her end products; whereas an employee can be evaluated on various aspects of his/her work according to the company’s policy and procedures.
The more an employer has the right to direct and control the work performed by the worker, the more likely the worker is an employee.
What financial control do you have on your workers and their work performance?
Expenses and Reimbursement. An independent contractor pays for the expenses incurred during and for the work performed (i.e., office, equipment, tools and mileage); whereas an employee is reimbursed by the employer for expenses incurred for the work performed.
Profit and Loss. Regarding profit/loss, an independent contractor provides his/her own services and is subject to profit/loss. In contrast, an employee is not subject to profit/loss, but the company he or she works for is.
Payments versus Wages. There is also a key difference in how employees versus independent contractors / freelancers are paid. An independent contractor is paid a flat fee or an hourly rate without taxes being deducted. However, an employee is paid a regular wage amount for a specific time period (hourly, weekly, bi-weekly) with taxes being deducted.
Tax Obligations. It’s also important to note that an employer has different tax obligations based on the worker’s classification:
- For an independent contractor, an employer does not withhold or pay any taxes on payments to independent contractors. Independent contractors are responsible for their own taxes.
- For an employee, an employer must withhold income taxes, and pay Social Security, Medicare taxes and unemployment tax on wages paid to an employee.
The more an employer has the right to direct and control the financial aspects of the worker’s work, the more likely the worker is an employee.
What is the working relationship between your company and the worker?
The important things to consider are contracts, benefits, length of the relationship, and exclusivity.
Contracts and Benefits. An independent contractor / freelancer has a written contract describing the services provided and scope of work, whereas an employee has an employment agreement, an offer letter, and a job description. Similarly, an independent contractor / freelancer does not receive benefits and will pay for such from his/her own pocket. However, an employee generally receives benefits including insurance, pension plan, vacation pay, and sick leave (although a part-time employee might not).
Length of Relationship. An independent contractor / freelancer usually performs work for a specific period of time and/or specific project. In contrast, an employee usually performs work indefinitely according to the job description. Working with a freelancer for an indefinite period of time undermines the independent contractor status.
Exclusivity. In addition, a freelancer / independent contractor works on projects for various employers and companies, while a (full-time) employee generally performs work for one employer.
Here’s an example to test your knowledge of the differences: employee versus independent contractor.
Now that you know all about the differences between employees and independent contractors, let’s try an example. Let’s consider a painter who comes to paint your rooms. How much control do you have? Does she paint lots of different homes? Does he bring his own paintbrushes and drop cloths? You tell the painter what color you want your walls painted but do you provide all the paint and tell her how many buckets of paint to use? How often do you work with the painter? Do you deduct taxes before paying your painter? Now, is the painter an employee or an independent contractor?
Hopefully, you now have more clarity on whether you have actually hired an independent contractor or an employee.
You might have seen that some factors you have checked may indicate that the worker is an employee, while other factors indicate that the worker is an independent contractor. Note that this is not an exhaustive list, and there is no specific number of factors that define a worker as an employee or an independent contractor, and no specific factor that has more weight than another.
The determination of employee versus independent contractor classification must be done by looking at the entirety of the relationship through the behavioral, financial and relationship factors. Be sure to thoroughly document your decision accordingly.
Please refer to the IRS website for more insight or ask your employment attorney.
Category: Freelancer Tips Compliance
Updated: July 13, 2021
Quick note: This is not to be taken as tax advice or legal advice or payroll advice. Since tax rules and laws change over time and can vary by location and industry, consult a CPA / tax advisor and/or attorney for specific guidance.