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1099 or a W-2: Employee vs. Independent Contractor

Operating a successful business can be stressful. It takes careful planning on the part of the business owner to ensure that the business is moving in the right direction. One small mistake can cause major consequences. A significant mistake that I regularly encounter with business owners is the misclassification of workers. Classifying someone as an independent contractor instead of an employee may seem minor, but, may cause financial ruin.

Many business owners tend to classify workers as independent contractors instead of employees to save money. If a worker is an employee, the business must withhold income, social security, Medicare, and unemployment taxes on any wages paid. In addition, the business has to match the social security and Medicare withholdings. If a worker is an independent contractor, the worker, not the business, is responsible for paying the taxes on monies earned. The most obvious choice would be to classify workers as independent contractors; however, the rule is that the relationship between the worker and the business determines the classification.

The IRS’s general rule is that “an individual is an independent contractor if the business has the right to control or direct only the result of the work.” The business owner cannot control what will be done and how it will be done. Essentially, the IRS is saying that the “facts and circumstances” will determine the correct classification. So how are business owners supposed to make the determination? Luckily, the IRS has issued some guidance to aid in making the determination. To determine how to properly classify a worker, the business owner must consider three categories; behavioral control, financial control, and the relationship of the parties.

Behavioral control refers to the amount of control the business has over the workers behavior in performing his/her duties. A worker is deemed an employee if the business has the right to direct and control the work performed. This is true even if the control is not exercised. Behavioral controls categories include: when and where the work is performed; what tools are being used; the degree of instruction given by the business; and, training the worker on how to do the job. Financial control denotes the business right to control the financial and business aspects of the worker’s job. They include: whether the worker has a significant investment in the equipment used; whether the worker incurs unreimbursed expenses; and, whether the worker is free to seek other business opportunities. The relationship depends on how the worker and the business view their interaction. This includes: contracts that describe the relationship; if the business is providing employee type benefits; and, if the relationship will last indefinitely or for a stated period of time.

Misclassifying an employee as an independent contractor will make the business owner liable for the employment taxes that should have been paid. This includes both the employee and employer portion of taxes. If a business owner classifies a worker as an independent contractor, he/she will need to be able to provide a reasonable basis for the classification.

To Learn more about worker classification please feel free to contact our office.

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