As a business owner, there are several questions you must ask regarding your employees. The business relationship between the organization (you) and the people performing the services is an incredibly important one. Only once these roles are defined will you know how payments should be treated. Defining individual roles is also how you figure out if that individual needs a 1099 versus a W-2 come year-end.
The Difference Between W-2 and 1099 Employees
If an individual is considered an employee, you as the business owner are required to withhold payroll tax. If they’re an independent contractor, you’re not required to withhold this tax.
The difference between an employee and an independent contractor also affects year-end planning/tax time. Employees receive Form W-2, while independent contractors receive Form 1099-NEC.
Year-end planning can be a confusing time for many businesses. We have resources to help.
Four Types of Worker Classifications
There are four ways to classify the person who performs the services for your organization: common law employee, statutory employee, statutory non-employee or an independent contractor. How do you know which one you have?
1. Common Law Employee
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, supervisory personnel—they’re all employees. Partners, however, are not employees.
2. Statutory Employee
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:
3. Statutory Non-Employee
These individuals fall into three categories: direct sellers, licensed real estate agents and certain companion sitters.
4. Independent Contractor
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.
The common-law test focuses on control, specifically related to two elements:
1. What must be done (the results of the work)
2. 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 is performed. A worker is considered an independent contractor if the employer can only control 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:
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 his/her 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:
Determining What Kind of Employee 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, 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.