So, you’re looking to hire your first employee? Congrats!
This a huge step for any business owner, but it also begs the question, ‘Is my new-hire a W2 employee, or a 1099 independent contractor?’ With many business owners, they have no clue what the difference is between W2 or 1099, which is not at all uncommon. This article is intended to assist with this important decision for your business.
One of the most important points to mention, is that classifying employees as either W2 or 1099 is not an all-or-nothing; it may likely be in your best interest to have a combination of both W2 employees and 1099 employees, depending on the roles you wish for these individuals to fill, as well as the amount of control that you wish to have over these employees.
Additionally, the IRS has no magic formula to determine whether employees must be
considered as W2 or 1099, however, it does have three main factors and a 20 questions checklist that it uses to assist. We’ll get to those factors and questions a bit later on.
The next important point, with 1099 employees, the employee is paid on an untaxed basis, and that employee is responsible for paying all applicable taxes. The 1099 employee is considered to be self-employed, and you as the business owner have entered into a contract with that individual to complete a specific job or fill a certain role. The 1099 employee is responsible for their own benefits, are free to set their own hours, and are free to use their own tools.
With a W2 employee, the individual is hired into your business under an employment agreement. The employer (business owner) is responsible for withholding and paying all applicable taxes owed to the IRS (Federal Income Tax, State Income Tax, Social Security, and Medicare). Additionally, in a W2 relationship, the employer is responsible for employer taxes: Social Security and Medicare, Federal Unemployment Tax, and State Unemployment Tax. Don’t let the thought of paying these various taxes scare you away from considering W2 hires, that’s what payroll companies like Southern Payroll & Benefits are here for, to file these taxes on your behalf. In this W2 relationship, the employer has more control over the employee, as the employer can dictate what they work on and when they work.
While the immediate reaction by many business owners may be that 1099 is going to be a better (cough-cough, cheaper, cough-cough) option for your business, it is important to again consider how much control you would like over this employee. As mentioned a bit earlier on, the IRS has no magic formula to determine whether an employee should be considered W2 or 1099; there are three main factors, and a 20 point checklist.
Three Main IRS Factors:
• How much control the employer has over the worker’s behavior and work results.
(Who controls training, where and what time the person works, what equipment they use?)
• How much control the employer has over finances. (Does the employer have primary control over the person’s profit or loss? How is the worker paid, are expenses reimbursed, who provides supplies?)
• What is the relationship between the parties. (Does the worker receive benefits? Is it a long-term relationship?)
IRS 20-Point Checklist:
How do you determine if a contractor should be paid on a W-2 or a 1099? The IRS has established a 20-point checklist the can be used as a guideline in determining whether or not a contractor can legally be paid on a 1099. This checklist helps determine who has the “right of control.” Does the employer have control or the “right of control” over the individual’s performance of the job and how the individual accomplishes the job? The greater the control exercised over the terms and conditions of employment, the greater the chance that the controlling entity will be held to be the employer. The right to control (not the act itself) determines the status as an independent contractor or employee. The 20-point checklist is only a guideline, it does not guarantee that a person is correctly classified. There is no one single homogenous definition of the term “employee.” Most agencies and courts typically look to the totality of the circumstances and balance the factors to determine whether a worker is an employee.
Following are the 20-points that have been established:
1. Must the individual take instructions from your management staff regarding when, where, and how work is to be done?
2. Does the individual receive training from your company?
3. Is the success or continuation of your business somewhat dependent on the type of service provided by the individual?
4. Must the individual personally perform the contracted services?
5. Have you hired, supervised, or paid individuals to assist the worker in completing the project stated in the contract?
6. Is there a continuing relationship between your company and the individual?
7. Must the individual work set hours?
8. Is the individual required to work full time at your company?
9. Is the work performed on company premises?
10. Is the individual required to follow a set sequence or routine in the performance of his work?
11. Must the individual give you reports regarding his/her work?
12. Is the individual paid by the hour, week, or month?
13. Do you reimburse the individual for business/travel expenses?
14. Do you supply the individual with needed tools or materials?
15. Have you made a significant investment in facilities used by the individual to perform services?
16. Is the individual free from suffering a loss or realizing a profit based on his work?
17. Does the individual only perform services for your company?
18. Does the individual limit the availability of his services to the general public?
19. Do you have the right to discharge the individual?
20. May the individual terminate his services at any time?
In general “no” answers to questions 1-16 and “yes” answers to questions 17-20 indicate an independent contractor.
However, a simple majority of “no” answers to questions 1 to 16 and “yes” answers to questions 17 to 20 does not guarantee independent contractor treatment. Some questions are either irrelevant or of less importance because the answers may apply equally to employees and independent contractors.
I hope this article has helped, and if you have any questions at all, don’t hesitate to
contact me or the Southern Payroll & Benefits team!