Employee or contractor?

April 11, 2018

Disclaimer: I am not an accountant or a tax professional, nor do I have formal training in these areas. The following represents solely my thoughts on the topic of employee vs. contractor classification. Please seek the advice of professionals before making any decisions.

With the rise of the gig economy, the internet, and remote working, the number of 1099 contractors is exploding. The problem is that far too many workers are being classified as 1099 contractors when they are indeed W2 employees. This misclassification impacts everything from individual incomes to the national budget and deficit.

Understanding the difference between a W2 employee and a 1099 contractor should be easy. If both parties agree there is a contractor / contractee relationship, that should be it, right? Actually, no. It is much more complicated than that. In fact, many workers classified as 1099 contractors are actually employees or statutory employees (nearly the same thing).

The IRS provides a range of ways to determine if a worker is an employee or a contractor. The basics come down to how much behavioral control and financial control the employer or contractee has over the worker, as well as the type of relationship the two share. Because there are penalties (for the employer) for misclassifying an employee as a contractor (but not the other way around), it is best to assume a W2 employee status. Furthermore, it should be well beyond doubt that a worker is a 1099 contractor before classifying the worker as such. If there is any doubt, the worker or the employer / contractee can file an SS-8 form and the IRS will determine the status.

If this all seems rather complicated, don’t worry. There are some reasonable guidelines you can follow to ensure a worker is, in fact, a 1099 contractor. As mentioned above, everyone should assume the worker is a W2 employee unless the worker fulfills all or a great majority of the following guidelines.

Contractor guidelines

Contractors and contractees should have an independent contractor agreement or contract in place.

Contractors have experience in the industry, i.e. not interns. Training is not provided, and the contractor has all the existing knowledge needed that will be used to perform the scope of work.

Instructions are not provided to the contractor other than information about the general scope of work to be completed.

No tools or materials are given to the contractor to perform the scope of work, except for those that are needed to perform the work. E.g. blueprints, logos, written materials, etc.

The scope of work is not required to be done in whole by any individual but may be performed by a contractor’s employee or a subcontractor (provided they are qualified to do the work). The use of subcontractors can be prohibited in the contractor agreement.

The contractor can hire employees or others to help perform parts of the scope of work or other areas of the business and it is best if they do this. E.g. contractors outsource marketing, legal, financial, and other areas showing they are working as a business.

The contractor only works sporadically for the contractee. If the contractor is required to work full time or for set hours of work, it is for a limited time and on a per-contract basis. All payments are contingent on the scope of work being done. Contractors are paid on a per contract price and not hourly.

Contractors contract with multiple contractees throughout the year. No more than 35% of the contractor’s annual income should come from a single contractee (preferably, less than this).

The contractor is not required to perform the work at any set time, but a set date that the work must be completed by can be required.

A contractor is not required to attend any progress meetings or submit progress reports to the contractee but may do so if it facilitates the delivery of the scope of work.

Contractors have a location their work is performed at and it is not within the contractee’s location. Contractors cannot be required to perform the work at a specific location, such as the contractee’s location. The exception here being work that is location-specific. E.g. a construction site.

Neither business expenses nor travel expenses are paid to contractor by the contractee. Contractors are responsible for all of their own business expenses.

Contractors ideally have proof of general liability insurance, but this legal requirement varies by state and the contractor’s business structure. If the contractor has any employees, contractor has worker’s compensation.

Contractors have an LLC, a corporation, a sole proprietorship, etc set up and all services are billed to the contractor’s company, not to any one individual.

Contractors should have an Employer Identification Number (EIN, or Tax ID), even if the contractor is the sole employee of their own business.

Contractors advertise their business to the public, including attending marketing events, having a website, having business cards, belonging to business organizations, and other activities that show they are running a business.

Neither party can terminate the contract unless the scope of work is not being met or unless otherwise specified in the contractor agreement.

Contractees have a current W9 from the contractor, preferably with an EIN, not a social security number, and send the contractor a 1099 each year.

For contractors that are questionable, a Form SS-8 should be completed and filed with the IRS so a determination can be made.

Think big, and the small is easy

All of these guidelines make perfect sense when you think big. Major manufacturers often do not make every single piece of a product. In many cases, it is better to have a contractor create specific portions of their product. In this case, the manufacturer contracts with another manufacturer under some sort of agreement. When you think about this kind of relationship, the above guidelines make perfect sense. Of course the contractor: has many other clients, is marketing their business, might sub-contract out portions of the work, does not work at the contractee’s location or necessarily during the same hours as the contractee.

Take that same thinking and scale back to what is so common today. Imagine a small business has a number of “contractors”. Do these contractors have their own businesses that they market and advertise? Do they work for a variety of clients? Do they work from their place of business and set their own business hours? If not, these workers are in fact employees. Even if these workers are part-time, and have other sources of income, they are very likely still employees, not genuine 1099 contractors.

Why this is important to the contractor or employee

More often than not, workers are pushed towards 1099 classification by would-be employers acting as contractees. Classifying a worker as a 1099 contractor often saves businesses a lot of money in the form of withheld benefits, taxes, and insurance. Not to say being a 1099 contractor is inherently bad; it has some major upsides. The trouble is that many contractees will try to cherry-pick the best features of both a 1099 contractor and a W2 employee.

As a W2 employee, the pros are that the employer: pays a portion of the employee’s taxes in the form of employer taxes, pays for unemployment and worker’s compensation insurance, provides training and equipment, and often provides benefits like discounted health insurance and paid time off. Generally speaking, expenses are rare and are compensated for by the employer. The tradeoff here is that the employer has more control over a W2 employee. The employer can tell the worker what work to do, how, in what order, as well as what hours to work, and where to perform the work. Similarly, most states allow an employer to fire an employee for any reason and at any time. The apparent security of employment has an underside few discuss.

Conversely, a 1099 contractor has its own set of hardships and rewards. The “bad” side is that a 1099 contractor pays more in taxes, risks losing money as profitability is not guaranteed, and they must secure their own stream of work via multiple clients. Similarly, 1099 contractors can only receive limited training, if any, must provide their own equipment and must cover their own expenses. In exchange, a 1099 contractor sets their own hours, works from any location they choose, can accept or decline work as they wish, and works with a multitude of clients (that they pick). 1099 contractors set their own price, and can’t be forced to attend regular meetings or provide status updates (deadlines must be met, but that is all). Any reasonable contractor agreement would prohibit the contractee from ending the agreement without proper cause, giving a 1099 contractor, in many ways, more security.

In the end, it doesn’t matter if you are a W2 employee or a 1099 contractor. The most important thing is that you understand which type of worker you are and what rights you have because of your worker classification. If you are classified as a 1099 contractor, you better: understand what that means, be treated like a contractor (not an employee) and leverage the benefits to your advantage. However, more often than not, workers are W2 employees and should receive the proper benefits.

Why this is important to the contractee or employer

In many ways, understanding the difference between a W2 employee and a 1099 contractor is even more important for the contractee or employer. Properly used, 1099 contractors can reduce cost, increase efficiency, expand your service roster and generally be great for business.

On the flip side, improperly classifying workers as 1099 contractors is a very risky proposition. Business owners must remember the burden of proof for a 1099 contractor classification is on their shoulders. Improperly classified 1099 contractors, if discovered, become much larger burdens than properly classified W2 employees. Not only will the business be liable for back taxes, they may also have to pay penalties and interest. Not only that, these fees would come in a large lump sum as opposed to over the course of a year or years. Flirting with improperly classified 1099 contractors is not a risk I would take.

Conclusion

The misclassification, and the mistreatment of workers due to their classification, most often stems from simple ignorance. Very often, neither workers nor business owners have taken the time to properly understand the difference in their respective roles. The unfortunate result is that both parties will end up engaging in activities that are improper, or dare I say, illegal. However, a small amount of education can get all parties in the correct role, and adhering to the applicable laws and tax codes. When everyone is speaking the same language, and operating from the same playbook, the use of 1099 contractors or W2 employees can be great for business and the national economy as a whole.