What’s the difference between an independent contractor (1099) and a full-time employee (W-2). This is one of the most asked questions these days in our On-Demand Society.
While two employees may work for the same company in the same office at the same time, they aren’t necessarily the same. In the United States, the Department of Labor has specific guidelines under the Fair Labor Standards Act (FLSA) on how workers are classified. They can be a full-time employee (and use a W-2 for tax purposes) or an independent contractor (and use a 1099 for tax Purposes). It’s important that companies classify their employee properly. Otherwise, they can face penalties. This is especially significant in our On-Demand Economy. For example, Uber has built its business on hiring 1099s. Every business owner needs to look at the dynamics of the relationship between their company and the worker. It doesn’t matter if you, the person being hired, has their own LLC or are called a business partner.
First, let’s focus on some high level definitions. The employer controls and decides what work will be done and how it will be accomplished. Conversely, an independent contractor is an individual or business that provides services to another individual or business on an as-needed basis. A full-timer, on the other hand, is considered permanent. Answer these questions to determine if any employee is an independent contractor or a full-timer:
- Is the person’s work an integral part of the Company’s business? The classic example is the electrician who sets up outlets on a new house. His work isn’t as important as scheduling projects?
- Does the worker’s s managerial skills directly impact the Worker’s opportunity for a profit or loss? If the worker is in business for himself, he will directly be impacted by the company’s profit or loss. For example, any equipment or marketing may reflect the managerial skills that will affect his opportunity to turn a profit; if the worker is in business for himself, he will be directly impacted by any profit or loss.
- How does a worker’s investment compare to his employer’s investment in the company? An independent contractor typically makes an investment towards a particular task or project. For example, they own and bring their own tools. They also pay their travel expenses. Note that the IRS will not look at multiple investments in isolation. So if the worker’s projects add up to having a significant impact on the company’s future, they will be considered a full-time employee.
- Does the work require a special skill set or initiative in an independent manner? Note: a highly skilled carpenter who provides a specialized service for a variety of local construction companies, such as building handcrafted cabinets, maybe be demonstrating the skill of an independent contractor. However, if he just doing what he is told, he is considered an employee. Another factor is whether the worker can handle an assignment in the manner they want; can they bring their own approach or methodology to a project?
- What is the degree of the Worker’s control? If the worker can determine their hours, other parts of their work, where they are work and a specific end date, they are considered an independent contractor.
- Does the agreement have a specific end date? Employers should have their contractors sign a contract for a project, which should include a list of specific deliverables and a specific end date.
- Does the person have to be at the office for certain times? Dictating when someone needs to be at an office could signal they are being treated as an employee.
- Does the person provide regular and written progress reports to the company? An independent contractor should send updates on their work, submit invoices on a monthly basis, and provide overall status updates on their projects. Most contracts specify “30-day net”, meaning the client has 30 days to pay a client after you receive your invoice.
- Does the individual pay their own social security and medicare tax (self-employment tax)? Although this is a criteria that is a bit after the fact, independent contractor’s must pay their own self-employment taxes (social security and Medicare tax). This amount is more than for the 1099 and then the W-2.
- Does the person have more than one client? Typically, an independent contractor will have more than one client as the work you hire them for doesn’t require them to work full-time on it. Having multiple clients allows them to replace a full-time salary.
For the small business owner, failure to properly classify a worker can cost a company millions of dollars in penalties. If there’s a chance that you have accidently misclassified a worker, you should make these correction as soon as possible. You should always consult with your accountant, a lawyer who knows about employment law or even your in house human resources specialist, who should know about 1099 tax laws and IRS compliance. Misclassifying someone can cost a lot of time and money.
On the other hand, for the independent contractor, who is also a small business owner in some respects, you should understand why you are being classified as a contractor vs. a full-time employee. There may be a simple and honest explanation as to why they are classifying you as a 1099. Even if they are doing it in error, it may just be because of a lack of understanding of employment law on their part.
*A variation of this post will appear on Xero.com in the near future.