If you’re considering hiring someone, and you’re trying to decide whether to classify them as a W-2 employee or independent contractor, you’ll want to pay attention to this section and the one that follows below that goes more in depth into the rules.
But there are also additional factors that are involved when you are just beginning to contemplate the creation of a position and how you intend to use that person’s services that can assist you in making the proper initial classification decision.
Key Factors include:
Work involved
Do you need this skill, access to this skill, only once or not often? Or do you imagine an ongoing stream of activities that are fairly normal for your kind of organization?
Available talent
In industries where it is hard to find full-time employees, working with a 1099 can allow you to hire scarce skills. This could involve re-thinking how to engage with the person you work with. For example, having a cybersecurity expert develop a program?that your IT team executes instead of your IT team owning the entire program end-to-end.
Payment
Freelancers and independent contractors take the profits and losses from their business and set their own fees. Many times this can be higher for hourly or project rates in order to compensate for self-employment taxes, business expenses and other costs.
In contrast, when bringing on a W-2 employee you must consider their salary and bonuses if applicable, paid time off, benefits, and employer taxes to determine the overall cost.
Different tests for 1099 vs W-2 employees
Accounting for those factors, the Internal Revenue Service (IRS), the Department of Labor (DOL), and Equal Employment Opportunity Commission (EEOC), as well as individual states can provide some guidance on distinguishing an employee from a freelancer or independent contractor.
Common law rules of the IRS
Federal tax law applies the rules of common law. The test has three broad categories that are determinative of the worker’s proper classification:
- Behavioral control. This looks at the whether or not the company has the right to control and direct the work of the service provider and the provision of training and instruction to the worker.
- Financial control. This one considers whether the individual has a profit or loss, invests in tools and facilities and has non-reimbursed expenses from the work.
- Nature of relationship. Part of this analysis of the characteristics of the nature of the work arrangements considers the presence of a written agreement between the parties, the nature of the relationship, and whether the individual receives employee-type benefits.
Under this test, none of these factors is an exclusive criterion in determining classification.
You must consider all of the above and you must consider any other relevant tests when deciding if someone is an employee or an independent contractor. Examine the totality of the relationship, examine the level of control, and record all of the factors which contribute to a finding.
When in doubt, classify as an employee. You can also obtain an official determination from the IRS by filing Form SS-8. But an IRS determination can take months.
DOL Economic Reality Test
The DOL uses what is called the “economic reality test” to establish that those workers are entitled to minimum wage, overtime and other pay and time related protections under the Fair Labor Standards Act.
This test considers as important factors such:
- How integral the services provided are to the business of the principal
- The permanence of the relationship
- The individual’s investment in buildings and equipment
- Control by principal – nature and extent of control
- The individual for the opportunity to profit and to lose
- The degree of initiative, judgment or foresight in open market competition with others which is necessary to the individual’s success
- The extent of autonomous organizing and running of the business
DOL economic reality test
As it pertains to federal nondiscrimination laws, the presumption is that, unless stated otherwise, a worker is an employee and entitled to legal protection.
The EEOC’s guidance documents provide a number of factors which suggest a worker is an employee as opposed to an independent contractor including:
- The worker does the job when, where and how the employer wants.
- It does not require much skill or expertise.
- The tools, materials and equipment are provided by the employer.
- It occurs on the premises of the employer.
- The worker remains in a continued relationship with the employer.
- The worker can also be assigned other projects by the employer.
- Work hours and Duration of job are set by employer.
- They pay their workers by the hour, week or monthly instead of paying an agreed cost to perform a certain job.
- The worker does not employ and pay assistants.
- The work performed by the worker is integral to the employer’s business.
- The worker is not carrying on an independent trade or business of their own.
- The worker receives insurance, leave or workers’ compensation through the employer.
- The worker is treated as the employer’s employee for taxation (i.e., the employer deducts federal, state and social security taxes).
- The worker can be terminated by the employer.
- The worker and the employer have this belief that they are creating an employer-employee relationship.
State employee classification tests individual
Other states have tests of their own that are stricter than the federal tests. For example, many states apply the ABC test as a means to determine unemployment insurance eligibility and/or wage and hour coverage or other benefits.
In this test, a worker is an employee unless all three of the following are:
- No control. The work is not done, but, under the direct supervision of the organization.
- Business as unusual. The work performed by such worker is not business necessary work or is performed off-site.
- Regularly employed. The work is performed by the worker in an independent capacity and in the traditional nature of the trade, occupation or business that is similar to the work done for the organization.
But, the ABC test isn’t necessarily all of the factors applicable in every place, so check your relevant state laws and codes.
Fines for misclassifying an employee
The costs associated with misclassifying an employee can be astronomical.
The costs for misclassifying an employee can be astronomical. If a worker is mistakenly classified as a 1099, the employer may be fined and liable for back employment taxes, for violation of minimum wage law and/or overtime enforcement of any state and federal laws.
If there is a clear trend of behaviors or if the Dept. of Labor believes that the misclassification was done willfully, the employer can even be faced with criminal charges. They may also be exposed to being sued by those workers. So it pays to stay compliant.
The Takeaway
Check that the following requirements have all been met before assuming someone to be an independent contractor. “If the worker does not pass these tests, they will be regarded as an employee and will have access to all the rights and benefits of employees as provided for by all laws”.
