From ride-sharing apps to the rise of mobile delivery services, many Americans have turned to the gig economy to earn extra money. Currently, 36% of employed individuals are independent workers, and this number will only increase. Your business can benefit from self-employed contractors, but it’s important to understand how to classify these individuals with the IRS.
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What is a 1099 independent contractor?
A 1099 contractor is a freelancer who completes work for your company on an as-needed basis. They aren't full-time employees, so they don't qualify for a salary or benefits. Instead, you pay them based on the agreement you outlined with that individual. 1099 contractors are usually hired for a specified period of time to help with a specific task or project.
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What is the difference between W-2 employees and 1099 independent contractors?
The main difference between W-2 employees and 1099 contractors is whether your business withholds taxes from that worker's paycheck. When you hire a W-2 employee, you're required to withhold Social Security, Medicare, and any state income taxes for that employee. When you hire a freelancer, they are responsible for federal and state tax payments.
There are serious consequences for misclassifying workers, so it's critical that you clearly distinguish whether you’re hiring a W-2 employee or a 1099 contractor. In most cases, a worker generally should be classified as an employee if the following are true:
- You control the details of how the work is performed.
- You control most aspects of that person's job, like how they're paid and whether their expenses are reimbursed.
- You provide the office space, equipment, and supplies needed for that person to complete their work.
- You provide employee benefits, like insurance, retirement plans, or vacation time.
Workers generally should be classified as independent contractors if the following are true:
- The individual controls when and how they perform their work.
- They use their own equipment and supplies to complete tasks.
- They provide services to several different clients who pay them directly for their work.
[Read more: What is Tax Form 941, And Who Needs to File It?]
Hiring a W-2 employee vs. a 1099 independent contractor
Employees and freelancers can benefit your business in different ways — let's review the advantages and disadvantages of both types of workers.
The advantages of hiring a W-2 employee
W-2 employees are hired by a company for an indefinite period of time with the intent that they will stay with the company long term. They're required to comply with the company's rules and policies to maintain employment, giving employers more control over when and how work is produced and the tools they use.
The disadvantages of hiring a W-2 employee
Businesses are required to provide more resources to W-2 employees than 1099 independent contractors, including tools, training, and onboarding. They must also cover business expenses on behalf of the employee. Businesses can pay more per employee than they anticipated.
The advantages of hiring a 1099 independent contractor
Independent contractors generally operate on short-term contracts, assisting companies with specialized projects before moving on to other clients. This allows small businesses to work with specialized individuals without needing to go through a laborious hiring process.
Contractors are a great option for businesses that need temporary assistance at an affordable price. They usually provide their own tools and don't need much training, saving a company money and resources.
The disadvantages of hiring a 1099 independent contractor
Companies have less control over when and how work is produced by independent contractors. These workers set their own schedules and can use whatever tools they prefer to get the job done, so the quality control isn't the same.
And since most freelancers juggle multiple clients, they may be less committed to your business. If a contractor bails on you at the last minute, you may scramble to complete that project on your own.
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If you're unsure how to classify your employees, you can file a Form SS-8 with the IRS. They'll review the nature of the relationship between your company and the employee and give you an official determination.
Long-term costs of each employee type
There are very different costs that come with hiring a 1099 contractor as opposed to a full-time employee. Let's say you hire a new employee with a salary of $100,000 per year. You also must factor in up to 30% more for benefits.
Employers also pay a percentage of their employees' Federal Insurance Contributions Act (FICA) taxes, which is another 7.65%. And you may need to provide office space, equipment, and training, which can cost up to an additional 15% of that person's salary.
Here's how these costs break down for that employee:
- Base salary: $100,000
- Benefits: $30,000
- FICA taxes: $7,650
- Other expenses: $15,000
So the total cost of hiring that individual is $152,650 annually. By comparison, a freelancer may charge a higher hourly rate or per-project rate, but they cover their taxes, benefits, and expenses.
[Read more: How to Get the Employee Retention Tax Credit]
Insurance and benefits considerations
Another major difference between W-2 employees and freelancers is that employees qualify for health insurance and benefits. If you have more than 50 employees, you're required to offer health insurance to 95% of your staff. The exact cost of health insurance coverage can vary widely, but the average annual premiums for family coverage are $22,463.
Your business is also required to pay into the state's unemployment insurance fund, which usually costs around 6% of payroll. And some employers offer additional benefits, like a 401(k), disability insurance, and paid time off (PTO).
What are the penalties if you misclassify employees?
Between 10% to 30% of employees are misclassified as 1099 independent contractors every year. Classifying employees as independent contractors means a company can avoid paying Medicare and Social Security taxes, as well as various employee benefits.
However, if you're caught misclassifying your employees, your business faces hefty fines and penalties. These penalties can vary depending on whether the IRS determines the mistake was international or not. If you made an honest mistake, you may have to pay penalties and interest for every W-2 employee who was misclassified.
But if the IRS determines you intentionally misclassified employees, it can impose additional fines and penalties, like paying 100% of both the employer and employee’s share of FICA taxes. The IRS may also charge criminal penalties of up to $10,000 per misclassified worker and up to five years in prison.
The government takes employee misclassification seriously, especially since underreported tax liabilities represent 80% of the country's gross tax gap in the United States.
How to protect your business from employee misclassification penalties
Misclassifying an employee impacts the employer and the worker. As an employer, you face legal ramifications for the mistake while the worker loses benefits and protections owed to them. Workers incur additional tax responsibilities and have to pay more money out of pocket.
If you're unsure how to classify your employees, you can file a Form SS-8 with the IRS. They'll review the nature of the relationship between your company and the employee and give you an official determination. This process can take several months to complete, but it may be worth the wait if you want to hire many workers with the same roles and responsibilities.
If you need to quickly determine how to classify a worker, consult with an employment attorney or tax professional. They can help ensure your new worker is properly classified, plus they can review your contracts to determine whether your business is following local and state laws.
You can also ensure that your business is compliant by regularly conducting internal employee misclassification audits and drafting standardized independent contractor agreements. This can ensure all your gig workers and your business are clear about expectations and payment details.
Is a W-2 employee or 1099 independent contractor better for your business?
W-2 employees are beneficial to businesses that operate on specific processes and are looking to commit to an employee's growth for an extended period. These employees are going to be more dedicated to the business in the long term and will require more extensive training and resources. Their work will also be tailored to your company's specific needs.
[Read more: What to Know About Taxes When You’re Running a Family Business]
For companies seeking help with a one-off project, hiring a freelancer is often an easier and cheaper solution than hiring a new employee. Just do your due diligence to ensure that the freelancer truly offers valuable skills that your team doesn't have readily available and can meet your work expectations.
This article was originally written by Miranda Fraraccio.
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