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  • Writer's pictureNick Andriacchi

What determines an Independent (1099) vs an Employee (W2)

I recently met with a client who had some questions about independent contractors, or commonly referred to as 1099’s (named after the IRS form). Using independent contractors may benefit staffers under certain circumstances. For starters, the staffing company does not pay employer taxes, workers compensation etc. And because these contractors are not employees, HR resources are not used and employment records, tax filings etc. are not kept. Plus, there is more flexibility in terms of payment to the contractors. For example, independent contractors can be paid lump sums for services provided with credit terms. The nature of the relationship with your contractor is similar to any other vendor.

But the IRS is very particular about the difference between employees and independent contractors because of whom is responsible to record, file and pay payroll taxes. Federal and state government agencies are on the lookout for businesses that use independent contractors to evade Social Security, Medicare, unemployment taxes and workers compensation and disability insurance. Companies that are audited and determined to be using employees misclassified as independent contractors pay back taxes (including the employee taxes), penalties and interest.

Subsequently, the IRS uses Common Law Rules to provide evidence of the degree of control and independence to determine a worker’s tax status. Those rules fall into three categories:

The first is Behavioral Control - whether or not the employer has control over how work is done. For example, if the employer requires that they outline how, when, and where to do the work, through a specific time schedule or use of specific equipment owned by the company, or all of the above, the worker is an employee, and therefore should receive a W-2 with the proper tax withheld. An independent contractor has a set deadline, but no particular restrictions on when or how to do the work, as long as it meets the customer’s contract. The contractor therefore receives a 1099 and must pay self-employment tax instead.

Next is Financial Control. The three principles of financial control involve significant investment, expenses and opportunity for profit or loss. If the worker is financially invested, perhaps through acquiring a piece of equipment themselves and are not reimbursed by their employer for these and ongoing expenses, they are considered an independent contractor. Usually, the contractor’s company is the entity that receives payment for services rendered.

Finally, Relationship of the Parties, which concerns whether the worker is treated as an employee or a vendor. If a worker is provided benefits such as paid sick and vacation days, health insurance, or pensions the worked is considered to be an employee. Even a contract stating the relationship of the parties as client-vendor can be ignored if the actual details of the relationship show something different.

If a worker satisfies all of these requirements that determine their tax status, they can be considered a subcontractor. A W9 form must be issued to any independent contract (or its firm if incorporated) that earns more than $600 and a 1099 must be issued at the end of the year.

Aside from IRS troubles, what happens if there is an injury and the individual has been mis-classified as a 1099? First of all, I doubt the insurance carrier will pay the claim, since that no premiums were paid on the injured individual. I know from my meat market days, we never paid anyone cash or as “casual help” specifically for workers comp reasons. Second, the company has likely bought itself a lawsuit. The worker can sue on the basis of the misclassification. That claim may raise the lack of workers’ compensation as one issue but also carries the possibilities of unpaid benefits, overtime and ACA compliance etc.

The last question, will the client pay the invoice if its found that the labor provided was misclassified as a 1099? In my experience, its doubtful as the staffing company makes a representation that it is compliant with the labor laws.

See Internal Revenue Code section 3509 for more information. The easiest way to avoid this is to consult a CPA or employment attorney or submit an SS-8 form to your local IRS office for a decision - but be aware - their determination could take at least six months.

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