Payroll Classification Issues: W-2 vs Independent Contractors

For small businesses, it is crucial to understand the difference between Independent Contractors and W-2-earning employees. There are benefits and drawbacks to the employee and employer for both classifications. However, the IRS and local government agencies are strict on these classifications. For unintentional mistakes, the IRS will assess penalties of $50 for each misclassified worker, 1.5% of wages, 40% of FICA taxes not withheld by the employee, 100% of the matching FICA taxes the employer should have been paying, and 0.5% of the unpaid tax liability per month up to 25%. For small businesses, these substantial amounts could bankrupt a company.

W-2 Employees

W-2 employees are unique because they are subject to payroll tax laws. Wages paid to employees are subject to Federal Income Tax withholding, Medicare, Social Security (FICA), Federal Unemployment (FUTA), State Unemployment (SUTA), paid and withheld by the employer. Consult your tax advisor for more information on what amounts paid to employees are taxable. Other than being relatively more secure, one advantage of being a W-2 employee is that the employee is not responsible for remitting their income tax withholding. Conversely, the employer has more tax payments to make and withhold on behalf of the employee.

W-2 employees must fill out Form W-4. This form determines the amount of income taxes to be withheld from regular wages throughout the year. This should be filled out before the first paycheck for the employee. Once it has been completed for that job, there is no need to fill out another one unless the employee wishes to change their withholding. If that is the case, it is the employee’s responsibility to fill out the new W-4 and submit it to the employer. For employee’s trying to figure out how much they should withhold, the IRS website offers a withholding calculator that specifically tells them how to fill out their W-4.

Independent Contractors

Payroll taxes for independent contractors are not the employer’s responsibility, but rather the independent contractor themselves on their income tax return. The employer issues the independent contractor a 1099-NEC (Non-employee compensation), which they report on their individual income tax return. This income is treated as self-employment income. The independent contractor is subject to self-employment tax (essentially the employee and employer portions of FICA, although they receive a deduction for half of that amount). The benefits of the independent contractor classification is that the worker effectively receives more cash at the time of the job (because the taxes are deferred), and the employer does not have to pay any employment taxes. The drawbacks of this classification are that they are subject to strict rules regarding who qualifies as an independent contractor, and as stated previously, misclassification can be costly for the employer. Further, while the contractor may benefit in the short term, ultimately, they are still liable for the same amount of FICA tax. Finally, independent contractors are (usually) unable to receive unemployment compensation.

As an employer with correctly classified independent contractors, it is crucial to have a completed Form W-9 on file. The W-9 provides the employer with the taxpayer identification number of the independent contractor. Suppose the employer does not receive a correctly filed W-9. In that case, they must invoke backup withholding of 24% of contractor payments and remit them to the IRS. If the payer fails to do so, they can be held liable for the total amount of backup withholding that should have been paid.

Common-Law Test

Although not technically legally binding, the IRS uses a standard test to determine a worker’s employment status. Employment status is also subject to different state and local standards. Some of the following tests have more weight than others, while some have blurred lines between how employees and independent contractors satisfy them.

1. 1. 1. Instructions – Employees must adhere to instructions, or the employer controls when, where, and how the employee works.
      2. Training – Employees must be trained by the employer, while a contractor follows their own guidelines and methods to complete the job.
      3. Integration – Employee services are usually integrated within the business.
      4. Services rendered personally – When employees render services themselves, the employer is interested in the methods and results.
      5. Hiring Assistants – The employer hires assistants and pays workers. Independent contractors hire, supervise, and pay their assistants.
      6. Continuing relationship – Employees generally have a continuing relationship.
      7. Set hours of work – Employees usually have set hours to work.
      8. Full-time required – Employees may be required to work full-time. Independent contractors can usually work the hours of their choosing.
      9. Work done on premises – Employees usually work on the premises, while contractors may sometimes work elsewhere.
      10. Order or sequence set – Employees must sometimes follow a specific order or sequence set by the employer.
      11. Reports – Employees may be required to submit reports, which shows control by the employer.
      12. Payments – Employees are paid based on a specific interval. Contractors are usually paid by the job or commission.
      13. Expenses – Employee business and travel expenses are generally paid by the employer.
      14. Tools and materials – The employer usually furnishes the appropriate tools for employees.
      15. Investment – Contractors often have significant investments in their facilities, tools, and materials.
      16. Profit or loss – Only independent contractors can suffer a loss. Employees can only make a profit.
      17. Works for more than one person or firm – Independent contracts are generally free to work for two unrelated firms.
      18. Offers services to the public – Independent contractors may be available to the public.
      19. Right to fire – Employees can be fired, while independent contractors cannot so long as they produce the contracted result.
      20. Right to quit – Employees can quit their jobs without significant liability. At the same time, a contractor has agreed to complete a specific job, and not doing so can lead to considerable liability.

Other Considerations

Overall, it is crucial to understand and adequately classify workers as either employees or independent contractors and fill out the proper paperwork. Not doing so can lead to extreme consequences and effectively bury a small business. We at Summit CPA recommend using a payroll service to deal with all the employment issues that may come up. This can help relieve some of the confusion that these classifications may cause.

With the rise of the “gig economy,” in recent years, the treatment of these workers as either employees or independent contractors has been under scrutiny. The IRS has detailed specific rules and information to know for both employers and workers in the “gig economy,” which may be helpful to understand. 

If a mistake has been made in classification, several steps can be taken. If workers believe they have been misclassified as an independent contractor, they can fill out Form 8919. Small businesses that wish to properly reclass their employees/contractors while paying minimal back taxes can utilize the Voluntary Classification Settlement Program (Form 8952) if not under audit by the IRS. The taxpayer will pay 10% of the employment tax liability due in the most recent tax year (no penalties or interest) and make the change prospectively. 

Questions?

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