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1099 vs W-2: What You Don’t Know Could Cost You

Editorial Team

5 min read
Image of employee at laptop
Photo by Christin Hume on Unsplash

Misclassification of employees as independent contractors can result in significant penalties.

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It’s common for many employers to refer to independent contractors as “1099” and employees as “W-2” workers after the IRS forms used for reporting purposes. However, simply providing a worker a 1099 Form doesn’t make them an independent contractor. The classification must always be made on the basis of whether the worker meets federal and state tests for independent contractor status. Different tests are used to determine whether a worker is covered by a particular law or benefit. Below is an overview of a few of these tests.

Federal Tests

Taxes

The Internal Revenue Service uses the Common Law Test for federal tax purposes. The test has three broad categories to determine the appropriate classification of a worker:

  • “Behavioral control” examines whether the company has the authority to direct and control the work of the service provider and looks at whether the worker receives training and instruction.
  • “Financial control” looks at factors such as whether the worker realizes a profit or loss, makes investments in tools and facilities, and has unreimbursed expenses.
  • “Type of relationship” examines the nature of the relationship. This includes whether there is a written contract between the parties, the permanency of the relationship, and whether the worker is entitled to employee-type benefits.

Under this test, no one factor stands alone in making a classification determination. You need to weigh all factors (and take into account other applicable tests) when determining whether an individual is an employee or an independent contractor. Look at the entire relationship, consider the degree of control, and document each of the factors used in making a determination.

When in doubt, err on the side of caution and classify the worker as an employee. You may also request an official determination from the IRS using Form SS-8. However, it can take at least six months to get an IRS determination.

Wage & Hour

The Department of Labor (DOL) uses an “economic realities” test to determine whether workers are covered by the Fair Labor Standards Act (FLSA) and entitled to minimum wage, overtime, and other wage and hour protections.

Under this test, the following factors are considered significant:

  • The extent to which the services rendered are an integral part of the principal’s business.
  • The permanency of the relationship.
  • The individual’s investment in facilities and equipment.
  • The nature and degree of control by the principal.
  • The individual’s opportunity for profit and loss.
  • The amount of initiative, judgment, or foresight in open market competition with others required for the individual’s success.
  • The degree of independent business organization and operation.

Note: The Trump Administration issued a final rule that would have amended the test, but the Biden Administration has delayed implementation of the changes until at least May 6, 2021 and proposed rescinding the rule entirely. Watch for developments closely.

Equal Employment Opportunity (EEO)

Under federal nondiscrimination laws, a worker is presumed to be an employee (and therefore entitled to protection under EEO laws) unless they meet certain tests. The Equal Employment Opportunity Commission (EEOC) looks at factors suggesting a worker is an employee and not an independent contractor, such as whether:

  • The employer has the right to control when, where, and how the worker performs the job.
  • The work doesn’t require a high level of skill or expertise.
  • The employer furnishes the tools, materials, and equipment.
  • The work is performed on the employer’s premises.
  • There is a continuing relationship between the worker and the employer.
  • The employer has the right to assign additional projects to the worker.
  • The employer sets the hours of work and the duration of the job.
  • The worker is paid by the hour, week, or month rather than the agreed cost of performing a particular job.
  • The worker does not hire and pay assistants.
  • The work performed by the worker is part of the regular business of the employer.
  • The worker is not engaged in their own distinct occupation or business.
  • The employer provides the worker with benefits such as insurance, leave, or workers’ compensation.
  • The worker is considered an employee of the employer for tax purposes (i.e., the employer withholds federal, state, and Social Security taxes).
  • The employer can discharge the worker.
  • The worker and the employer believe that they are creating an employer-employee relationship.

State Tests

Some states have their own tests, some of which are more difficult to satisfy than federal tests. For example, a number of states use the ABC test for determining whether an individual is covered under unemployment insurance and/or wage and hour laws or other benefits. Under this test, a worker must be considered an employee unless all three of the following factors are met:

  • The worker is free from the control and direction of the hirer in connection with the performance of the work, both under the contract for the performance of such work and in fact;
  • The worker performs work that is outside the usual course of the hiring entity’s business; and
  • The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed for the hiring entity.

Please check your applicable state tests to ensure you’re in compliance.

Before classifying an individual as an independent contractor, make sure they’ve met all applicable tests. If the worker fails to meet these tests, the individual is an employee and is entitled to all the rights and benefits of employees under the applicable law.

Automate how you manage your freelancers, 1099 contractors, and contingent workers through WorkMarket®, an ADP company.

This story was originally published on SPARK, a blog designed for you and your people by ADP®.

This information is provided for informational purposes only and should not be construed as legal, financial, or tax advice. Readers should contact their attorneys, financial advisors, or tax professionals to obtain advice with respect to any particular matter.

This information was prepared by a third party. Clover assumes no responsibility for its content.

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