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Why Understanding W2 vs 1099 is Important for Small Business Owners

By December 21, 2020January 19th, 2021Small Business

We are seeing states become more aggressive around the misclassification of W2 vs 1099 employees. As a small business owner, it’s important to understand the IRS rules behind W2 vs 1099 employees and ensure that you are compliant. This blog covers the following:

  • IRS rules for classifying W2 vs 1099 employees
  • Pros and cons of W2 vs 1099 employees for small businesses
  • Consequences for misclassification

You can also view our YouTube video, which has more details and examples on this subject.

IRS rules for classifying W2 vs 1099 employees

There can be significant fees and penalties for misclassifying employees. In addition, employees can sue their employer in some scenarios. So, let’s dive into the important IRS rules for classifying W2 vs 1099 (also known as independent contractors) employees. There are 3 key rules that you should be aware of when analyzing if your employees are W2 vs 1099:

  1. Behavioral
  2. Financial control
  3. Type of relationship
Behavioral

This rule has to do with how much control the employer has with the worker’s job and how the worker gets the job done. For a 1099 employee, the employer has less control over behavior. Are you telling the worker what tools to use, when to work, or how to do the work? If so, they are more likely to fall under the category of a W2 employee. If they are bringing their own tools/software and simply agreeing on requirements, they are more likely a 1099 employee.

There is a lot of gray area with the behavioral rules, but here are some key indicators to look for:

  • Performance reviews – You can’t have performance reviews for a 1099 employee. You can for a W2.
  • Training – A 1099 employee brings and trains themselves for the most part, although an employer could help an independent contractor understand how the job needs to be done. A W2 employee is primarily trained by the employer.

All in all, the more detailed instructions you give a worker, they more likely they are to be a W2. If you are just agreeing on a set of requirements or end-project, and the worker gets the job done with their own tools, on their own time, they are more likely a 1099 employee.

Financial Control

There are three areas of financial control to be aware of:

  1. Who invests in the employee? A 1099 employee invests in their own tools, software, training, etc. A business invests in these things for their W2 employees.
  2. Are business expenses reimbursed? A 1099 employee does not get reimbursed for business expenses from the employer. Whereas a W2 employee can be reimbursed from the employer for various business expenses.
  3. Can the employee lose money? A 1099 employee can actually lose money on a project or job. Since they are covering their own costs, they could spend more than they receive from the employer. On the other hand, a W2 employee will always get paid for the work they do, no matter how much that work costs the business.
  4. How is the employee paid? A 1099 employee dictates the payment terms. This includes the mode of payment and when they get paid. If the employer is dictating payment terms, the employee is a W2.
Type of relationship

The type of relationship an employer has with its employee helps determine a W2 vs 1099 employee. Here are a few things to look for:

  1. Contract terms – A 1099 employee usually has a contract with end dates. Whereas a W2 employee won’t have end dates of employment written in the employee contract.
  2. Benefits – A 1099 employee does not get benefits from his or her employer. A W-2 employee does.
  3. Permanency of the relationship – A 1099 employee will generally have a less-permanent relationship with the employer. A W-2 employee has an indefinite relationship with the employer.
  4. Type of services provided – 1099 employees are often not doing work that is a core service of the employer’s business. On the other hand, employees that are doing core competency work of the business are likely to be W-2 employees. For example, a law firm would need a good explanation as to why its lawyers are 1099 employees. A law firm hiring someone to do their marketing would more easily be able to explain them as a 1099 employee.

Pros and Cons of W2 vs 1099 employees

Why hire a 1099 employee?

1099 employees have a lot of benefits for small businesses. With a 1099 employee, a business does NOT need to do provide or pay the following:

  • Employer benefits
  • Employer taxes
  • Unemployment insurance
  • Overtime wages
  • Minimum wages
Why hire a W2 employee?

With all those benefits, there are still some reasons you would want to consider hiring an employee as a W2 vs 1099:

  • A long-term commitment from the employee
  • More control over their schedule and day-to-day work
  • A W2 employee is usually more committed to your business

Consequences of Misclassification

If you are found misclassifying W2 vs 1099 employees, you may face the following consequences:

  • Being held liable to pay employment taxes
  • The employee could sue you as an employer
  • You may owe back benefits that they should have received

As previously mentioned, states are becoming more aggressive with W2 vs 1099 employee compliance. By following the IRS rules and understanding the basics covered in this blog, you’ll have a foundation for doing what you need to as an employer to ensure compliance. If you need an help, feel free to reach out to the gurus.