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1099 or W2? The Difference Between Contractors And Employees Is More Costly Than You Think

FieldPulse | September 21, 2016

employee or contractor

The difference between a contractor and an employee isn’t negligible. It’s tempting as a small business owner to reduce your payroll expenses and tax liabilities as much as possible, but employee misclassification is a serious crime. Misclassifying your employees could cost you thousands in penalties and FICA back-taxes.

In some situations, though, you really do need an independent contractor, and as long as their duties fit the description, contractors are a great resource for small businesses. They can help you scale to meet temporary work demands, provide specialized services you can’t train for in-house, and give you valuable 3rd party support when working on projects that don’t match your specific wheelhouse.

If you’re starting a new service business or you’re looking to diversify your current workforce with more position types (there are actually seven employment classes in the US), this guide will help you figure out what kind of employment system is best for your business.

The Basics

It’s relatively easy to figure out whether someone is a contractor or an employee in an office setting, but the lines aren’t as clear for service businesses. The general rule is that the way someone works dictates their employment status, but it can also be influenced by scheduling, provided equipment, and the specific job sector they work in.

In simple terms, if you tell an individual when, where, and how to work, they’re probably an employee. That’s classified as behavior control, which the IRS takes into account when looking at employee classifications. Independent contractors, on the other hand, are their own business. They control when, where, and how they work, and they’ll treat you as a client instead of a boss.

This sounds simple on paper, but it gets tricky, though when you break it down into real-world examples. Let’s say you run a cleaning company. Your staff drive their own vehicles to each location, but they use supplies and wear uniforms your provide. They’re given specific directions on how to clean, but they’re not directly monitored or micro-managed by you or other core members.

Are they employees, or contractors? Would that change if they brought their own cleaning supplies? What if they drove company vehicles? What if they set their own schedules?

If they work in teams, drive company vehicles, and/or don’t have control over their own schedules, they’re employees. But if all you do is connect the cleaners with clients and leave the rest up to them, they’re contractors. If you split the difference… Well, it’s murky.

To quote the IRS: “If you have an employer-employee relationship, it makes no difference how it is labeled. The substance of the relationship, not the label, governs the worker’s status.” This means that the relationship is largely determined by how it’s perceived by everyone involved. If everyone is on the same page, it can work out fairly well. If you’re deliberately misclassifying employees in order to save a buck or two, you’re going to have a bad time.

How to Use Contractors Properly

Chances are, you’ve already worked with a contractor or two. If you paid someone to design your website, create posters, or run an advertising campaign, you’ve worked with contractors the right way: on a limited-scope project with an explicit contract and a deadline, or on a retainer for recurring remote services without direct oversight.

Contractors aren’t staff, they’re experts. You might work with a contractor for tax services or payroll or even staff training, depending on the scale of your operations. Generally speaking, though, contractors aren’t going to be working on-site using your equipment; if they are, you may be misclassifying a part-time employee.

Outsourcing labor is common, and small businesses are turning to contractors for help with increasing frequency. Contractors and specialists exist in almost every field, which means that with a bit of advance research, the right networking, and clearly written contracts that follow the rules of contract work, it’s entirely possible to scale your workforce the right way.

Most examples of improper contract work arise from either excessive money-saving attempts or an improper understanding of the difference between contract work and part-time work. Contractors aren’t just cheap labor sources; they’re specialists that should be brought in for specific tasks that don’t need the same oversight that an employee would.

For service businesses, this might mean sub-contracting work out to smaller businesses that operate in your same market when demand increases or bringing in a certified expert from another city to help you train and improve the efficiency of your existing workforce. You could build relationships with independent contractors who specialize in a subset of your overall service portfolio for assistance on larger projects. There are countless ways that independent contractors can help your business.

“Contract labor,” on the other hand, is rarely legal on the individual level. If you’re not working with a staffing company that handles the requisite taxes and benefits of full-time supervised laborers, chance are it’s not a legal relationship.

How Much Employee Misclassification Can Cost You

Right off the bat, if you’re caught misclassifying your employees you’ll be faced with a $1000 fine per employee and the back taxes you owe as their employer. It isn’t uncommon for the IRS to add additional fees and penalties on top of that, depending on the exact nature of the situation.

In 2013, the IRS expanded their voluntary worker classification settlement program. The goal of this program is to aid workers in determining their proper employment status and seeking adequate compensation from employers who misclassify them. This program specifically helps workers at small businesses who otherwise would not receive help due to the size of their case, making it harder for business owners to keep their employees in the dark.

It’s important to remember that there’s no such thing as a 1099 employee and with the ever-increasing number of wage and employment lawsuits, most employees know how they should be classified. Handling the taxes and benefits of your workforce, especially if you’re faced with high turnover, might be time consuming, but with the variety of digital tools on the marketplace made specifically for service businesses, there’s little excuse for cutting corners.

When in doubt, talk to a lawyer. If you’re looking to onboard new staff or change your hiring practices, you can also fill out form SS-8 to get the official word on how the position in question would be classified. In the current market it never hurts to be thorough, and classifying your employees the right way is ultimately good for business.

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