Regardless of the industry or size of the business, employers are responsible for the correct classification of their workers. Failure to correctly classify a worker as an employee or independent contractor can make the mistaken employer responsible not only for the worker’s back employment taxes, but also penalties, warns the IRS.
And the IRS is cracking down on employers who misclassify workers and don’t pay their fair share of employment taxes. Therefore, it’s crucial for small business owners to understand how a W-2 employee differs from a 1099 independent contractor.
A number of factors go into worker classification for tax purposes, and pursuant to IRS Publication 15-A, they fall into three broad categories: behavioral control, financial control, and relationship of the parties.
It’s important to note that no single factor stands alone in making the worker classification determination; all factors together must be considered in order to make the proper classification.
1) Behavioral Control – As a small business owner, if you provide extensive instructions on how your work is to be carried out and training on required work methods and procedures, then the IRS will suggest that an employer/employee relationship exists. Detailed work instructions may include how and where the work will take place, what equipment to use, and where to purchase supplies and equipment. Similarly, if you want the job to be carried out in a certain way, and provide training to this effect, you’re likely hiring an employee, not an independent contractor.
2) Financial Control – Three factors come into play when determining whether you have financial control over an individual: significant investment, expenses, and opportunity for profit and loss.
- Significant investment – While there is no specified dollar amount, if your worker has to make a significant investment in order to work, he may be an 1099 independent contractor vs. an employee.
- Expenses – If you don’t reimburse your worker for some or all of his businesses expenses, then this suggests that he is an independent contractor.
- Profit or Loss Opportunity – If your worker has the opportunity to incur a loss or realize a profit, then she may be in business for herself, suggesting an independent contractor status.
3) Relationship – Factors that illustrate how the small business owner and worker perceive the relationship include presence of employee benefits and information included in a written contract. For instance, if you provide your worker with insurance, a pension, and paid time off, then the IRS may say this signifies an employer/employee relationship. If other facts or circumstances surrounding the relationship aren’t conclusive for worker classification purposes, a written contract often is. The written contract should clearly detail what you, as the business owner, intend to get out of the business relationship.
Conclusion: Take time now to review each worker in your small business to determine if they are classified correctly, and make sure new hires are brought onboard with the proper classification. It’s also a good idea to seek guidance from an human resource professional or employment law attorney.
Additionally, both the small business employer and the worker can ask the IRS directly to make a worker classification determination by completing and filing with the IRS Form SS-8: Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.