by Corey McCaster | May 21, 2019
Many small business owners may find themselves faced with the dilemma of determining if a new hire is considered a W-2 employee or a 1099 independent contractor. Unfortunately, they often make the wrong decision. According to the Internal Revenue Service (IRS) nearly 3.4 million employees are classified as independent contractors when they should be reported as employees. Before going any further in your decision-making process take a few minutes to consider the following:
Many accountants recommend hiring all staff as W-2 employees in order to avoid the hefty penalties and fees the Internal Revenue Service (IRS) charges. These penalties and fines can accrue when an employer – knowingly or unknowingly – misrepresents a relationship with a worker and fails to withhold taxes. According to IRS Code Section 3509, typical consequences for this action is:
- $50 for each W-2 form that the employer failed to file because of classifying workers as an independent contractor;
- penalties of 1.5 percent of the wages not withheld, plus 40 percent of the Federal Insurance Contributions Act (FICA) taxes (Social Security and Medicare) that were not withheld from the employee and 100 percent of the matching FICA taxes the employer should have paid. Interest is also accrued on these penalties daily from the date they should have been deposited.
- penalties can also equal up to 0.5 percent of the unpaid tax liability for each month and up to 25 percent of the total tax liability.
To avoid fines and penalties the burden of proof is on the employer to prove that in fact a relationship in question is one of a contractual nature and not that of an employee-employer.
The IRS has established a 20-point test to help employers gauge the type of relationships they have with their workers. Known as the “right-to-control test,” it acts as a guide to determine the degree of control a company exercises over the way the work is performed by an independent contractor. The more questions on the test that are answered with a “yes,” the greater control the company has, making it more likely that it should be collecting, submitting, and withholding taxes on behalf of its workers.
Questions on the test can be counter intuitive. Take some time to familiarize yourself with the test. It may help you avoid onboarding someone in your company incorrectly as an independent contractor.
Though the IRS asks you to consider the 20 questions to help you determine employee status, you can start by asking these four questions:
- Is the position short-term or short in nature?
- Will you be providing the tools the employee works with?
- Do you control the work environment or when they clock in and out?
- Do you incentivize their work? Is there a bonus structure or bonus compensation for the work?
When in doubt, seek additional expertise to help you make the determination on whether or not you’ve hired a W-2 employee or a 1099 independent contractor. There are many no-cost and low-cost entrepreneurial resources available to assist with this type of issue.