How to Classify Workers (1099 v. W2)

 

Determining whether a worker is an employee (W2) or independent contractor (1099) is a tricky but essential process for business owners.  Why? Well misclassification can cost businesses lost time and money (in the form of back taxes, fines, and other penalties). Get. This. Right.

The three factors below are balanced in an effort to determine whether the worker had control of what work will be done and how it will be done. Generally, if the payer only directs the worker on what the result of the work should be, and the worker has control over how to reach that result, then the worker is an independent contractor. The more control the payer has on how the work was done, the more likely the worker was actually an employer. The three factors are broken up into sub-categories and are explained in some detail below:

What is the significance of being classified an employee vs. an independent contractor

  • Determining employer liability 

  • Seeking damages in excess of workers’ comp

  • Different tax treatment 

Three Factors we look at:

  1. Behavioral Control 

  2. Financial Control 

  3. Relationship 


1. Behavioral Control

There are four categories of behavioral control that the IRS considers: 

  1. Type of instructions given

  2. Degree of Instruction

  3. Evaluation System

  4. Training 


Types of Instructions Given: 

A worker is typically classified as an employee if they are subject to the payer’s instructions about when, where, and how to work. Some examples include what tools should be used, where to purchase those tools, and which specific individual performs each part of the work. An independent contractor would make these decisions, while an employee would have the payer make these decisions. 

Degree of Instruction: 

Put simply, the more detailed the instructions given by the payer, the more control they exercise over the worker, and the more likely the worker would be classified as an employee. It is also important to note that even if no instruction is given, if the payer retains the right to give instruction during the work period, then that would factor into classifying the worker as an employee.  

Evaluation System: 

If the payer implements an evaluation system used to measure how the work is being performed during performance, then that would factor into classifying the worker as an employee. If instead an evaluation is used to measure only the end result, that could either factor into classifying the worker as an independent contractor or an employee. 

Training: 

The payer providing the worker with training indicates that they want the job done in a particular way. This factors into classifying the worker as an employee. 


2. Financial Control

There are five categories of Financial Control that the IRS considers:

  1. Significant investment 

  2. Unreimbursed expenses

  3. Opportunity for profit or loss

  4. Services available to the market 

  5. Method of payment


Significant Investment: 

Typically, more investment by the worker indicates that they are more likely an independent contractor. However, this determination is made on a case-by-case basis and a significant investment will not automatically categorize the worker as an independent contractor. The remaining categories should give a better idea of what that means. 

Unreimbursed Expenses:

If the worker is reimbursed for their expenses, it is more likely that they would be categorized as an employer. An important factor is whether the worker incurs fixed ongoing costs regardless of whether work is currently being performed or not. This would be indicative of an independent contractor classification. 

Opportunity for Profit or Loss: 

Having the possibility of incurring loss due to the significant investment in equipment would indicate that the worker is an independent contractor. 

Services Available to the Market: 

A worker who seeks out further business opportunities through advertisement and maintaining a visible business location are typically categorized as independent contractors. 

Method of Payment: 

Regular wage or a salary is typically indicative of an employee, even when earned on commission. A worker who is payed a flat fee for a job is usually considered to be an independent contractor. 


3. Relationship 

There are four categories of Relationship that the IRS considers: 

  1. Written Contracts

  2. Employee Benefits

  3. Permanency of the Relationship 

  4. Services Provided as Key Activity of the Business


Written Contracts: 

A written contract that indicates that a worker is an independent contractor is not conclusive to categorizing the worker as an independent contractor, although it is still relevant. 

Employee Benefits: 

Benefits such as insurance, pension plans, and paid vacation days are typically not offered to independent contractors. However, once again it is important to note that the absence of such benefits does not conclude that the worker is an independent contractor. 

Permanency of the Relationship: 

A worker hired for a single job is indicative of an independent contractor, while a worker hired with the expectation that the relationship will continue indefinitely is indicative of an employee. 

Services Provided as Key Activity of the Business: 

If a worker is hired to provide services that are considered a key activity of the business, then it is more likely that the payer will have the right to direct and control the worker’s activities, thus indicating an employee classification. 

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How-tos, ResourcesRob Massar