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, whether they are an employee or independent contractor, is an incredibly important one. Only once these roles of independent contractor vs. employee are defined will you know how payments should be treated. Defining the individual roles of independent contractor vs. employee is also how you figure out if that individual needs a 1099 or a W-2 come year-end.
The Difference Between W-2 and 1099 Employees
Wondering about the difference between an employee and contractor? Understanding the role of independent contractor vs. employee is fairly simple. 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 can skip withholding.
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
Worker classifications go beyond just independent contractor vs. employee. There are four main ways to classify the person who performs 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:
- 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.
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 of employment.
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 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:
Behavioral Control
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.
Financial Control
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 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 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.
More questions? We’ve compiled everything you need to know about 1099 and W-2 forms in our e-books.
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