1099 contractors are freelancers who work independently instead of for an employer. While the work that a contractor completes can be similar to the work of a formal employee, the laws distinguishing these two workers are important for employers to understand.
Many companies look to hire contractors for short-term projects. And while some working scenarios suit independent contractor work, contractor misuse and misclassification are rampant and often result in serious fines. If the IRS (Internal Revenue Service) suspects that a company intentionally misclassifies workers in the United States, then it may impose a fine as high as $500,000 for a corporation.
This guide includes information that helps determine if your 1099 contractors, or independent contractors, are operating compliantly in the U.S., and insights to avoid common traps that lead to hefty penalties.
What Is the Difference Between W-2 and 1099?
Millions of companies around the world use independent contractors to complete work for their business. However, that doesn’t mean that these relationships are compliant. Before you determine if your independent contractors are compliant, you must understand what differentiates a contractor from a full-time employee in the eyes of U.S. law.
One of the main differences between a full-time employee and an independent contractor is how they file taxes with the IRS. A full-time employee uses a W-2 form, and a contractor uses a 1099. For W-2, or full-time employees, taxes are automatically deducted from their paycheck each month, and the employer pays the government. 1099 workers, or contractors, must run their own payroll and submit the proper amount in taxes to the government quarterly.
How Do You Determine the Correct Job Status for Your Workers?
Properly paying and filing taxes is critical; however, this is not the only distinction that the IRS makes between full-time employees and contractors. The IRS uses three main criteria that determine whether a worker is full-time or a contractor. The three criteria include:
1. Behavioral Control
According to the IRS, independent contractors have control over how they perform their job duties. A worker is a full-time employee when a company has the right to direct or control the employee’s day-to-day duties, even if the company does not exercise that right. For example, if you offer workplace flexibility, and employees can work from home or choose their working hours, that doesn’t mean you can classify them as a contractor. On the job training, providing work materials, and giving detailed instructions on how to operate on a daily basis are strong indicators to the IRS that the employee is full-time, not a contractor.
2. Financial Control
In general, companies have less financial control over independent contractors than full-time employees. For example, contractors are usually free to take other business opportunities and work with multiple companies, a common conflict of interest for full-time employees. The method of payment also differs between full-time workers and contractors. Full-time, W-2 employees receive a regular hourly or annual wage paid out weekly, bi-weekly, or monthly. Contractors are more often paid a flat rate per job and can negotiate their own payment terms.
3. Relationship Type
There are additional critical differences between employer and contractor, which contrast with those of a full-time worker. One important detail that defines each relationship is benefits. Businesses providing benefits, such as insurance, a pension plan, vacation pay, or sick pay, have employees. Companies generally do not grant these benefits to independent contractors.
How long the relationship between contractor and company lasts is another important distinction. An expectation that the work will continue indefinitely, rather than for a specific project or period, is generally seen as evidence intended to create an employer-employee relationship.
Avoid Misclassification When You Hire
Hiring an independent contractor instead of an employee seems like a simple way to hire quickly and avoid a long-term contractual commitment. However, the benefits may not outweigh the risk of noncompliance. Before you hire a contractor, have a thorough plan in place that ensures the type of work and relationship is compliant. Some things to consider before hiring include:
1. Set Expectations from the Start
Once you know what clearly defines a full-time employee from a contractor, it is relatively clear as to which option fits your hiring needs. If you know you want to dictate how your future employee works, or envision a long-term working relationship, it is not a good option to hire an independent contractor.
2. Create a Written Agreement
It is in the best interest of both the employer and the contractor to have a written agreement that fully defines the relationship before starting any work. This agreement also helps the IRS determine factors in the “relationship type” category discussed above, if there are questions about the contractor’s status.
3. Pay the Contractor Properly
Remember that a key differentiator between a contractor and a full-time employee is how your company pays them. If you choose to hire a contractor, work together to establish a flat rate per job, and do not withhold taxes from their paycheck.
4. Convert Misclassified Contractors
Now that you understand the differences between contractors and full-time employees, assess your current workforce. This step is especially critical if you have overseas operations, as misclassifications in foreign countries can come with steeper fines and punishments. Once you identify any misclassified contractors, take steps to convert them to full-time employees through an International PEO (Professional Employer Organization) partner, if your company or the contractor is outside of the U.S.
An International PEO acts as your company’s Employer of Record by helping you onboard individuals as compliant employees rather than contractors. An International PEO partner handles all compliance, payroll, and risk mitigation for your converted employees, while you continue to manage your business. This solution allows companies that hire internationally to avoid additional fines and penalties.
Addressing Independent Contractor Risk is More Important Than Ever
In the U.S., consequences for misclassified contractors vary. In general, classifying an employee as an independent contractor with no reasonable basis for doing so makes employers liable for employment taxes. However, if there is intent to cover-up misclassified contractors, the punishment is more severe.
It is best to evaluate your contractor relationships early on and make adjustments as necessary. It is usually easier to bring on contractors as full-time workers, rather than deal with the headache of paying misclassification fines.
If you choose to hire overseas, hiring foreign independent contractors comes with many more risks and considerations. Before you hire contractors overseas, check out Velocity Global’s helpful resources on determining foreign contractor compliance, or contact us today to speak with an expert.