How to decide between a 1099 vs W2

One of the most common questions we get from small business owners is whether to classify a worker as a 1099 contract laborer, or an employee of the company.  The easiest answer to all business owners is to pay someone as a 1099, thus avoiding paying payroll taxes all together.  Fortunately, the IRS has established guidelines on who you can pay as a 1099 and who you must pay as an employee.  The guidelines are basic and there is a great online tool from Intuit that I recommend using when determining a 1099 vs W2.  Even during certain situations with clients, this tool has helped provide a clear solution to a difficult issue.

The IRS has outlined 3 rules in determining whether someone is a 1099 or an employee:

• Does your company control or have the right to control what the worker does and how/when his/her job should be done?

  • Does the individual determine his/her own work schedule or is it set by your company?

  • If additional workers are needed to complete a job who does the hiring?

• Does your company provide the necessary tools, supplies, equipment to perform the job?

  • How is the worker paid? Does he/she submit and invoice to you for payment or a time card?

  • Does the worker have his/her own tools and supplies to use on the job?

  • Does the worker have his/her own business or does she rely completely on your business?

• What type of relationship does your company have with the worker?.

  • Is this a temp/project basis employment contract?

  • How often will they be working for you? Part time/Full time?

These rules are easy to follow but are also convoluted.  One of the biggest areas that our clients struggle with are part time employees.

The question we get asked all the time is, "If they are only working a small amount of hours each week, why should I not pay them as a 1099 so I do not have to pay payroll taxes on them?"

The easiest way we explain to our business owners is when someone is paid as a 1099, then they will have to pay self employment tax on those earnings.  Most of these part timers make very little money and are in a situation where they are not able to put money aside to pay for the additional 15.3% self employment tax.

Another aspect to classifying your workers appropriately is to avoid any risk/trouble down the road from the various Government reporting agencies.  There have been numerous instances that we hear about through clients or other professionals that some company has dug themselves a hole with the Department of Labor, IRS, State Agency, etc.  Workers that are not well informed on these types of earnings are excited that they won't have taxes taken out of their pay thus providing them more money to spend.  Then tax time comes around and you issue them a 1099 for a decent sum of money.  They become upset over the large tax bill they have to pay and begin to report you to the various agencies.

Guess what?

If the worker was supposed to be paid as a W2 employee and you chose to pay them as a 1099 laborer, you will be personally liable for the unpaid payroll taxes that should have been withheld and paid to the various agencies.  It is called the Trust Fund Recovery Penalty from the IRS.  That penalty doesn't get assessed on your company though.  This is one of those few penalties that gets to pierce the all mighty "Corporate Veil" and will be assessed on the business owner himself/herself.

When the agencies come to inspect the company records, they will be looking at all of your classifications.  Typically, if they find one they will find more which just adds to the tax bill.

Another way a business gets caught with paying a worker improperly is when the worker is fired/quit and goes to collect unemployment.  You can't collect unemployment as a 1099 laborer since no unemployment tax was paid to the state agency on their behalf.

Guess what?

They are going to fight it and report the company to the various Government agencies.  Again, the agencies will come knocking trying to get the story straight and make sure the everything is correct with the business.  Just like the previous example, if they know of one issue and they find more, the company is only digging a bigger hole.

Now there are several instances when it is OK to pay someone as a 1099 and not a W2 employee:

• May times a small business owner is hiring someone and they usually have a trial period before the worker becomes an actual employee.  Typically the trail period is a few weeks to at most a month and the worker can be paid as a 1099;

• This is common practice among businesses, they are able to see if the worker is a good fit before they offer the worker benefits, perks, etc.

We recommend you consult with your CPA, bookkeeper, payroll specialist or the IRS directly to make sure the company is doing everything correctly.