Small business owners constantly have difficult decisions to make. From cash flow to marketing, running a business isn't all fun and games. You likely started your business with a dream (I know I did!), but eventually business owners may get to the point where they realize they can't do it by themselves anymore.
As someone who deals with small businesses on a regular basis, I have found there is often confusion about what the next step should be. Some business owners will just start sending Zelle payments to new workers. A client of mine even began making weekly cash withdrawals from their bank account and giving the cash directly to a new office worker that was working for them! Not a smart move for many reasons, and as we will soon see, such decisions are often misguided. The purpose of this post is to make you aware of the common differences between the different worker classifications and to explain the necessary factors every business owner should consider before deciding whether an individual they are hiring should be classified as an employee or as an independent contractor. To be clear, you can't just decide what works better for you. You need to follow these guidelines.
Let's first discuss the basics. When hiring individuals, a business usually has two options:
A) W-2 employee (salary/payroll)
- or -
B) 1099 independent contractor (often called "freelancers" or "consultants")
Two main differences between a W-2 employee and a 1099 independent contractor, as it pertains to the hiring company:
1) An employee will generally cost the employer more money, as the employer will need to pay Social Security and Medicare taxes, as well as state-mandated insurances and other costs. There may also be benefits that are offered to employees. Many of these expenses are non-existent with independent contractors, although depending upon the industry, there may be some insurance costs.
2) An independent contractor arrangement is simple; you pay them exactly what they earn, with no tax being withheld. There usually isn't any confusion. An employee, however, will have tax withholding from their salary, which can sometimes lead to questions/complaints from employees. If you are an experienced employer, you may be familiar with some version of, "I don't understand why I owed money when I filed my personal tax returns. You must have made a mistake!"
Why would any hiring company choose to pay someone with a W-2 rather than a 1099?
Given the above facts, why would any hiring company choose to pay someone with a W-2 rather than a 1099, which is less costly and simpler? The answer is that it's not up to the hiring company to choose. Let's first establish a rule: The IRS considers a worker an employee if a company exercises sufficient control over when, where and how the work is done. Don't worry - we're going to explain this below with three detailed tests that should help you further. The main idea to keep in mind is that an independent contractor basically works for themselves, while an employee is controlled, to some extent, by the company.
Test #1: Behavioral - Do you have the right to control what the worker does and how they do it? If you can, that fits into the category of being an employee. For instance, if your company sets the work location, hours and day-to-day processes, that dictates a level of control indicating the workers are employees. If the company provides on-the-job training, that is an additional sign we are dealing with employees.
Test #2: Financial - Do you control how they are paid and are their expenses reimbursed? If yes, that is a signal they are employees. Just to explain, employees will usually be provided with the tools that are necessary to complete a job. An employee working as an office manager would not normally be expected to purchase their computer on their first day in the office. If, however, you hire a plumber (independent contractor) to complete a repair, you generally would not pay for their tools or equipment.
Test #3: Type of Relationship - Do you have an ongoing relationship with the worker and are there benefits? For example, if you have an indefinite relationship with this worker that provides them with health insurance coverage, that points toward an employee relationship.
If these tests seem a little confusing, be thankful - the IRS used to have a 20 point checklist! It is possible that some of these tests will indicate a worker is an employee, while others will indicate a worker is an independent contractor. There is no "magic" number of tests that "makes" the worker into an employee or an independent contractor. The key is to focus on the relationship as a whole and determine the extent of control the company has over the worker. If you are still in doubt about how to determine a particular worker’s classification, don’t hesitate to reach out to a professional for assistance. Additionally, the IRS offers a form (SS-8) that you can prepare and send to them which presents all the facts to the IRS, who will then review the circumstances and inform you of the "official" status of this worker.
>Accounting insights by Aaron Shleifstein from A. Shleifstein & Co. CPA's.
A. Shleifstein & Co. CPAs is a full-service accounting firm, offering white-glove service. You've worked hard building your business. You continue doing your thing, while we handle all of your tax filings and help limit your tax liabilities.
