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The question of whether a worker is an employee or an independent contractor has been getting more attention in recent years. The rise of the gig economy, more states weighing in on the matter, and the consequences of misclassification are all players in the rising scrutiny.
In simple terms, employees receive an IRS Form W-2 and independent contractors get an IRS Form 1099-MISC. However, that’s barely scratching the surface. To ensure accurate classification, you need a solid understanding of W-2 versus 1099-MISC and what it means to be an employee versus an independent contractor. It also helps to know when (and how) to transition from one to the other.
Employers must complete a Form W-2 for each employee to whom they paid at least $600 in wages for the tax year. The W-2 shows not just wages paid to the employee but also federal and applicable state and local taxes withheld from those wages. In addition, the W-2 reflects other types of compensation made to — or on behalf of — the employee along with certain voluntary deductions subtracted from their pay.
You must file W-2s with the Social Security Administration (SSA) and furnish employees with their copy, both by January 31. If the deadline falls on a legal holiday or Saturday or Sunday, you have until the next business day to file and distribute W-2s. If you withheld state or local taxes from your employees’ wages, then you must file W-2s with the state or local taxation agency by the mandated deadline.
Takeway: Employee compensation and taxes are reported on Form W-2. The employee uses the W-2 to file their tax return(s).
Businesses must use Form 1099-MISC to report income for each non-employee to whom they paid at least $600 for services rendered in the tax year. For example, if you hire a freelancer to perform information technology services for your business and you paid them $600 or more for the year, you must give them a completed 1099-MISC. Note that Form 1099-MISC can be used for other purposes, such as to report rents, royalties, prizes, awards, and medical and healthcare payments.
The deadline for reporting a 1099-MISC (for non-employee compensation) to the IRS and the worker is January 31. Depending on your location, you may or may not need to file the 1099-MISC with the state. Michigan, for example, is part of the Combined Federal/State Filing Program. Therefore, businesses in Michigan don’t have to report 1099-MISCs separately to the state. As noted by the Michigan Department of Treasury, “The IRS will share this information with Michigan.”
Takeaway: Non-employee/Independent contractor income is reported on Form 1099-MISC. The independent contractor uses the 1099-MISC to file their tax return(s).
One of the easiest identifiers of an employee is that they’re paid through their employer’s payroll system. The employer must also pay and report the employee’s taxes withheld. However, paying them through your payroll system and administering their taxes do not automatically make them your employee. The true test lies in whether there’s an “employment relationship” that meets legal standards.
Unlike employees, who are compensated through payroll, independent contractors are paid through the payer’s Accounts Payable (AP) system and are ultimately responsible for reporting their own income and paying their own taxes.
Similar to employees, there are legal standards for determining whether someone is an independent contractor. Because circumstances vary, it can be difficult to arrive at the right conclusion.
Generally, the biggest factor is how much control you have over the worker.
With a W-2 worker (or employee), you have the right to control and direct their work activities. You can train them as you see fit, require that they work a certain number of hours per week, and tell them where to do the job.
With a 1099-MISC worker (or independent contractor), you can control or direct only the outcome of the work. Basically, you assign work responsibilities — including your expected deliverables — to the independent contractor and conduct limited tax reporting via Form 1099-MISC. However, you cannot control the independent contractor’s work activities or how they execute the assignment.
Legal standards for classifying employees and independent contractors:
Learning the different tests and deciphering which ones are applicable to your situation can be challenging. Moreover, due to the abundance of tests, a worker can potentially be an employee under one law and an independent contractor under another law. When the lines are blurred, it’s important to consult with an employment law expert.
So far, we’ve established that if a worker satisfies the required federal and state tests, they must get a W-2 or 1099-MISC, depending on where they fall on the classification scale. But what if you already have a working relationship with them and you’d like to switch them to the other side? While the transition is doable, there are some caution bells, which we explain below.
Converting a W-2 employee to a 1099-MISC contractor
As the gig economy continues to take flight, the chance of a business hiring an independent contractor is higher than ever. If the contractor you have in mind is already your employee, you can make the conversion if the nature of the working relationship has genuinely changed. Whether it’s because you’re downsizing, because the role has changed, or because the employee made the request, there must be a legitimate change in the working relationship.
“Organizations cannot use independent contractors to indiscriminately avoid the tax, equal employment opportunity and other legal requirements applicable to employees,” according to the Society for Human Resource Management (SHRM). Per SHRM, the following situations may be appropriate for an independent contractor:
Caution bell #1: Converting from employee to independent contractor involves terminating the employee. You must therefore adhere to federal and state employment laws plus company policies, including those requiring you to pay unused vacation or sick time upon termination.
Caution bell #2: If you terminate the employee and then hire them as an independent contractor but still treat them as an employee, they will not satisfy the legal definition of an independent contractor. Take, for example, the case of Baindurashvili, et al., v. Helpful Hands Transportation, No. A12-0657, Court of Appeals of Minnesota, 2012. The court agreed that the two former drivers who were converted from employees to independent contractors were due unemployment compensation because they had so little control over their work activities.
Caution bell #3: In the case of Vizcaino v. Microsoft Corporation, the court held that Microsoft had misclassified some employees as freelancers based on a number of factors. This included providing the freelancers with equipment and supplies and having them work the same base hours as regular employees. The freelancers also worked onsite and alongside the company’s regular employees. But although they were being treated as employees, they were not eligible for the same benefits that the company’s regular employees received. Microsoft ended up settling to the tune of $97 million.
Caution bell #4: Be sure to remove the reclassified worker from your payroll. As an independent contractor, they should now receive a 1099-MISC instead of a W-2.
Converting a 1099-MISC worker to a W-2 employee
Maybe you’ve worked with an independent contractor on several projects and you’re now ready to make them a permanent member of your team. Or maybe you classified them as an independent contractor when they’re actually an employee. Either way, you need to convert them to employee status.
Caution bell #1: Since the worker is no longer an independent contractor, an “employment relationship” has to exist.
Caution bell #2: As an employee, the worker is now protected by federal and applicable state and local employment laws. These might include FLSA, FMLA, EEO, ERISA, COBRA, OSHA, ADA, ACA, and state and local wage and hour statutes.
Caution bell #3: Switching an independent contractor to an employee may put you on the IRS’ radar. If the contractor was in reality an employee but failed to pay their taxes, you may be liable for the taxes that should have been withheld from their earnings plus your own portion of taxes. On the upside, if you have a “reasonable basis” for not treating them as an employee, you may qualify for relief from paying the taxes.
Caution bell #4: Be on the lookout for state legislation impacting the classification of independent contractors as employees. One example is California’s AB 5 law, also called the “gig worker bill.” Estimates reveal that nearly two-thirds of independent contractors in California are eligible for reclassification as employees under AB 5.
Note that if you’re eligible, you can reclassify your independent contractors as employees via the IRS’ Voluntary Classification Settlement Program (VCSP). The program allows you to reclassify employees for employment tax purposes and delivers partial tax relief.
Now that the independent contractor is an employee, they should be on your payroll — which means they should get a W-2 instead of a 1099-MISC.
Can an employee also work as an independent contractor for the same company?
According to SHRM, though this is a possibility, “it is not commonplace.” Other experts warn against this practice, noting that the safest course is have one classification status for the worker to prevent triggering red flags or inviting IRS or DOL investigations. If you’re considering having a worker be both an employee and an independent contractor, it’s critical that you defer to legal counsel.
The ramifications of employee misclassification can be substantial and far-reaching. Among them are:
The effects at the state level can be staggering. As noted by Michigan.gov, unscrupulous businesses in Michigan shortchange workers $107 million per year in revenue by misclassifying them as independent contractors or paying them off the books to escape paying their own share of employment taxes. This has prompted Attorney General Dana Nessel and Michigan legislators to carve out measures aimed at limiting payroll fraud, including worker misclassification.
It’s therefore vital that you properly characterize your workers and issue the correct tax forms, whether that’s Form W-2 or Form 1099-MISC. One way to minimize legal risks is to partner with a Professional Employer Organization — such as Axios HR — that can help make sure your employees are appropriately classified.
February 19, 2020
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