- You must clarify the roles of independent contractor vs. employee so you can determine whether an individual requires a 1099 or a W-2 at year-end.
- Worker classifications go beyond employee and independent contractor.
- If you’re unsure, Form SS-8 can help determine the status of a worker in question.
As a business owner, it's crucial to address questions about your workforce. The relationship between your organization and the people providing services, whether they're employees or independent contractors, is highly significant.
Once you clarify these roles of independent contractor vs. employee, you can determine the appropriate payment treatment and whether an individual requires a 1099 or a W-2 at year-end. If you're unsure about the distinctions between an employee and a contractor, understanding the roles of independent contractor vs. employee is fairly straightforward.
Employees and Independent Contractors
When someone is classified as an employee, it means you, as the business owner, need to deduct payroll taxes. On the other hand, if they're an independent contractor, you don't have to withhold taxes. This distinction between employee and independent contractor also impacts your year-end preparations. Employees receive Form W-2, while independent contractors receive Form 1099-NEC.
Types of Worker Classifications
Worker classifications go beyond employee and independent contractor. Here are the four main classifications for the people who perform services for your organization:
- Common Law Employees: The key to common-law rules is control. If the organization can control what will be done (the results of the work) and how it will be done (the method by which the work is performed), then the person performing the services is the organization’s employee. It doesn’t matter under common-law rules what your title is or how your workers are classified. Managers, support staff, and supervisory personnel are all employees, while partners are not.
- Statutory Employees: Common-law employees are not the only type of employees. Independent contractors can still be considered employees by statute if they fall under any of the following four categories:
- A driver who distributes beverages (other than milk) or food (meat, vegetable, fruit or bakery products), or who delivers dry cleaning if the driver is the organization’s agent or paid on commission.
- A full-time life insurance sales agent who sells primarily for one life insurance company.
- Someone who works at home on materials for an organization. The organization supplies the materials and materials must be returned to the organization if the organization furnishes specifics for the work to be done.
- A full-time salesperson who works on behalf of an organization with wholesalers, retailers, contractors or hotel operators, etc. as their primary business activity.
- Statutory Non-Employees: These individuals fall into three categories: direct sellers, licensed real estate agents and certain companion sitters.
- Independent Contractors: An individual who provides services to another individual or business. This individual is a separate business entity doing work on behalf of an organization.
How to Define the Employer-Employee Relationship
An employer-employee relationship is most often determined by the common-law test of employment.
The common-law test focuses on control, specifically related to two elements:
- What must be done (the results of the work)
- How it must be done (the way the work is performed)
An individual is considered an employee if the employer can control both aspects of the test; in other words, you have the right to control both the results of the work and how the work job is performed. A worker is considered an independent contractor vs. an employee if the employers can only control either the result of the work or how the work is performed.
How to Define an Independent Contractor
An important distinction for 1099 independent contractors is that they are, in fact, independent. But how do you really define independence versus control? The IRS uses three categories to help determine employee status:
Here, we’re talking about the right to direct or control how the worker performs a specific task. Specifically, this category looks at types of instruction given (what tools to use, what workers to hire, when the work is to be performed, etc.), if there’s an evaluation system to measure details of performance and if ongoing training is given. If these items are all present, it generally points toward an employee/employer relationship.
When it comes to financial control, the IRS looks at factors that point to control of the economic aspects of a worker’s activities.
Things to consider include:
- Significant investment: Has the individual made a significant investment in tools or facilities used to perform the task for your organization?
- Unreimbursed expenses: Has the individual chosen to incur expenses and bear the cost of the service provided for your organization?
- Services available to relevant markets: Does the individual make themselves available to other organizations or individuals similar to your organization?
If the answers to the above questions are yes, then you’re looking at an independent contractor relationship. Other items to note in this category include method of payment (hourly vs. flat fee for services) and opportunity for profit or loss (whether the individual is free to make business decisions affecting their own profit or loss).
Relationship of Parties
This category hinges on the question of how the worker and the business perceive each other in terms of intent concerning control. What does “intent concerning control” mean?
Here are some triggers:
- Intent of parties/written contracts: a written agreement or contract describing the worker as an independent contractor, methods of payment, expenses to be reimbursed, etc.
- Employee benefits: providing a worker with benefits, including paid vacation or sick pay, health insurance, life insurance, etc.
- Regular business activity: services performed by the individual are a key aspect of the regular business of the organization.
Determining What Kind of Employees You Have
If you find yourself second guessing if an individual is a W-2 employee or a 1099 independent contractor, there’s a special form known as Form SS-8. The IRS uses the information on that form, as well as any other information they can obtain from the parties involved from federal or state forms, to determine the status of the worker in question.
No set of factors will give you a definite answer. When the IRS looks at who is an employee and who isn’t, they look at all the facts and circumstances within that situation. Clarifying the roles of independent contractors vs. employees is critical to determining the appropriate payment treatment and whether an individual requires a 1099 or a W-2 at year-end. If you have questions or need help, Eide Bailly’s advisors are here to help.