Before the pandemic (and all the havoc it created), small business owners across the nation were concerned about hiring practices, including the 1099 vs. w2 debate. In addition, California had just enacted its new AB5 law, causing stress and confusion for independent contractors and business owners alike. The law, which went into effect January 1, 2020, mandated a 3-point independent contractor vs. employee test to determine the correct classification.
All three points must be true for a worker to be classified as an independent contractor:
- 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.
- 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.
As the controversy gained momentum in California over who the new law would hurt (businesses or independent contractors) and what it hoped to accomplish (granting protections and rights to workers), other states considered enacting similar rulings. During the pandemic, with so many layoffs, the controversy quieted down.
But in today’s post-pandemic economy, business owners are once again asking themselves, “Should I hire an employee or independent contractor?”
Contractor vs. Employee
Years before AB5 was passed, the IRS issued classification rules for how an independent contractor differs from an employee. In the IRS’s classification test, the control lies with the contractor and not the employer. In a typical employer/employee relationship, the employer controls the employee’s hours, work location, tools used, and where to make work-related purchases. If an employer imposes any one of these control factors, it indicates the worker is an employee. In addition, the more specific the directions given, the more the IRS was likely to classify the worker as an employee. Plus, elements like worker training or evaluations were considered employer direction, making the worker an employee in the eyes of the IRS.
However, for independent contractors, although the employer controls the end goal, like projects or campaigns, how that task is accomplished is in the hands of the independent contractor.
Likewise, the financial aspects of the relationship must be in the contractor’s control. Independent contractors are expected to use their own equipment to do the work and should not be reimbursed for expenses unless specified in the contract and included in the contractor’s 1099.
Finally, the IRS considered the relationship between the worker and the business. The contractor/business relationship cannot resemble an employer/employee relationship. The contractor cannot receive benefits or paid time off like those regularly given to employees. Unlike an employee, an independent contractor’s contract should contain a beginning and ending date.
In addition to reiterating the control rules of the IRS classification, AB5 tightened the rules around the scope of the work for hiring an employee vs. an independent contractor. Seasonal workers hired for short-term employment are not considered independent contractors because they perform work generally associated with the business. Part-time work still constitutes an employer/employee relationship. However, for example, if a web design company needed writers for client projects, they could hire them as independent contractors, as long as the design company does not offer editorial services as part of its business.
Another key differentiator is how the independent contractor conducts their business. The contractor should be able (if asked) to show that project work is how they earn money and that they have a variety of clients. Maintaining separate personal and business finances is advised. And it’s also recommended that independent contractors officially establish their businesses as sole proprietorships or limited liability companies (LLC).
1099 vs. W2 Employee
When it comes to recordkeeping, employer responsibilities, and how a worker is paid, there are clear differences between employees and independent contractors. Independent contractors need to fill out IRS Tax Form W9, which identifies the contractor’s personal information, including social security number or Federal Tax ID number. The business hiring the contractor then turns the form into the IRS.
Taxes are not withheld from the wages of independent contractors. The contractor pays estimated taxes quarterly and self-employment taxes on their personal tax form on April 15. Businesses must report wages for any independent contractor paid over $600 in a tax year. Wages for independent contractors are reported on Form 1099-MISC, Miscellaneous Income. Forms are due to the IRS, the state tax department, and the independent contractor by January 31. The IRS also requires businesses to submit Form 1096 (Annual Summary and Transmittal of U.S. Information Returns) by January 31. Your digital accounting system should be keeping track of wages and inform you which independent contractors need a 1099.
Whether part-time or full-time, employees are subject to a number of taxes by the federal and state governments—and sometimes by the city in which they work. Employees must fill out a W4 (Employees Withholding Certificate) when hired, which asks for their name, address, social security number, number of dependents, and any withholding adjustments. Employers are no longer required to turn in the W4 form to the IRS unless specifically asked for it. Now, the W4 stays with the company as an official record and is used to determine withholding taxes.
Employee wages are subject to payroll taxes, including federal income taxes, state income taxes, and FICA (Social Security and Medicare). Employers are also required to make a matching employer contribution for the FICA tax. As noted above, some cities also require employees and employers, or just the employee, to pay a local tax, which means the business must withhold the tax from the employee’s paycheck. Finally, unemployment taxes (SUTA) are typically paid only by the employer—the amount varies by state. Only employees in Alaska, New Jersey, and Pennsylvania contribute to their state’s unemployment tax.
Quarterly, employers are required to use Form 941 to report income taxes, Social Security tax, or Medicare tax withheld from employees’ paychecks. The employer’s portion of FICA is also paid quarterly.
By January 31, an employer must report employee wages and payroll taxes on IRS Form W2, Wage and Tax Statement. Employers are required to send W2s to the Social Security Administration, state, city, and local tax departments, but not the IRS. Employees must also receive a copy, and a copy stays with the business. In addition, the company must fill out and send Form W3, Transmittal of Wage and Tax Statements, to the Social Security Administration when you send Forms W2.
Payroll taxes can be confusing, especially if you have employees in different states. CorpNet can register your business for state payroll taxes with the Department of Revenue in all 50 states. Our specialists can also manage the process of registering your business for State Unemployment Insurance Tax (SUI) and State Income Tax (SIT), which saves you time and money.
Contact us today for help, so you can get back to growing your business.