W-2 vs. 1099 – A Primer for New Employers
When hiring, it’s important to delineate between W-2 employees and 1099 independent contractors. The status of someone who works for your company will determine how you pay them and how they remit taxes.
Employees and Independent Contractors
-Employees (sometimes called regular employees or W-2’s) are people who work for an employer who supervises the employee’s work – when, what, and how it is done.
-Independent contractors are professionals who offer business services to the general public. People such as doctors, dentists, accountants, construction contractors, and freelancers are considered independent contractors. Independent contractors are treated as self-employed and subject to self-employment tax (social security and medical) on their reported income.
Determining The Correct Classification
Determining whether an employee is an independent contractor (IC) or an employee is important because it determines whether payroll taxes (income taxes and FICA taxes) are withheld from the individual’s pay. Withholding taxes must be withheld from employee wages, but you do not withhold taxes from payments made to independent contractors. The IRS determines employee status for these purposes. Employee status (IC or employee) also matters in terms of pay and benefit status. The Department of Labor’s Fair Labor Standards Act only protects workers. This law establishes rules for minimum wage, overtime, child labor, OSHA and other safeguards.
How The IRS Determines Employee Status
The IRS uses three basic rules to determine the type of business relationship between employee and employer, based on the degree of control and independence of the employee.
-Behavioral control: Behavioral management examines the control an employer has over their employees. Does the employee give many detailed instructions, including where and when the work will be done? Is employer provided training available (meaning the employee may not already be qualified)? Are there built-in appraisal systems to track employee performance? Does the employee bring their own tools and accessories or does the employer provide them?
-Financial management control: This factor includes how the employee is paid, whether the employee can work for others at the same time, and whether the employee can make a profit or a loss. An employee who receives a salary and is prohibited from working for others and who does not share in the profits or losses of the business is likely to be a W-2 employee.
-Type of Relationship: The existence of a specific contract may indicate an independent contractor status, but this factor alone is not conclusive. If an employee is entitled to benefits, this constitutes an employment relationship. Another factor is the type of work of the person; if it is directly related to the company’s core business, they are probably employees. For example, a maintenance person would not be doing “corporate” work if they worked for a bank.
When In Doubt
Sometimes it is difficult to determine the status of an employee, but when in doubt, assume that the employee is an employee in the eyes of the IRS. If unsure, you can find out by filing Form SS-8 and requesting a determination status from the IRS. Note: The IRS does not make decisions on hypothetical situations, but only to resolve federal tax issues currently in play.
New DOL Regulations
The US Department of Labor has announced new rules to make it easier to determine whether a worker is an independent contractor vs. an employee. Note: The Biden administration has delayed the new DOL regulation and other proposed regulations until everything is reviewed.
An economic reality test helps to determine the independence, or lack thereof of the worker. Two key factors help determine whether an employee is economically independent: the nature and degree of job control and the employee’s potential for profit or loss based on initiative and/or investment. Several additional factors also play a role:
-The number of skills required for the job
-The degree of permanence of the employment relationship
-Whether or not the work is an essential part of the company’s product
Another Possible Worker Status
There is another possible status for employees called statutory employee (or non-employee). A legal employee is a cross between an employee and an independent contractor; they are treated as an employee from the point of view of employment taxation and as an independent contractor from the point of view of income taxation. Only four specific categories of employees can be designated as legal employees:
-Drivers who deliver (non-dairy) beverages, meat, produce or baked goods when they represent your company and receive a commission.
-Full-time life insurers who sell policies primarily to one company
-Workers who work at home on materials or goods you supply.
-Full-time traveling or urban salespeople if that is your primary occupation.
How Employees and Independent Contractors Pay Taxes
Employees are paid a salary or hourly wage, commission or a combination thereof, and may also be paid for OT. Employees are taxed on their income and receive a W-2 form that shows their annual earnings. As the employer, you also have to withhold federal and state income taxes and FICA (Social Security and Medicare taxes). Your company must also pay FUTA taxes based on the number of employees and unemployment rates. These taxes are not deducted from employee pay; only an employer pays them.
If someone works for your business as an independent contractor, you will not withhold federal or state income taxes or FICA taxes on the amounts paid, unless they are subject to withholding. Your company also doesn’t have to pay Social Security and Medicare taxes to independent contractors. An independent contractor must pay these Social Security/Medicare taxes on payments received as self-employment taxes. You must send an annual Form 1099-NEC to each independent contractor if you paid that person at least $600 during the course of the fiscal year.