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Is Your 1099 Contractor Really A W-2 Employee?

By Michael D. Cross, Jr., J.D.

Employment taxes are a significant cost of doing business for each small business. Employers must pay federal employment taxes equal to 7.65% of each employee’s pay up to $87,900 and 1.45% thereafter. In addition, quality employees often command additional benefits such as health care and retirement plans. Employer also must make certain to withhold a portion of each employee’s compensation for payment of federal and state income taxes. Prudent employers often contract with a payroll company to assist in meeting these obligations, and this also is an additional cost.

These expenses are not incurred, however, if the employer hires independent contractors (sometimes known as “1099 employees”). Although independent contractors may command higher base compensation, whether paid hourly or on a project basis, no additional taxes or withholdings are required. As such, many businesses, in an effort to minimize expenses and simplify bookkeeping, choose to “outsource” work to independent contractors instead of hiring additional employees. Various government agencies, however, including the IRS, the Department of Labor, state departments of revenue and labor, and state workers’ compensation boards, have substantial financial interest in making certain that individuals are not improperly characterized as independent contractors instead of employees. If the agency finds an improper characterization, it can impose substantial financial penalties upon the employer. For example, if the IRS locates such a situation, it will determine that the employer should have paid employment taxes and withheld income taxes and then impose penalties and interest charges upon the IRS, which may more than double the amount owed.

In analyzing whether an individual is an employee or an independent contractor, courts and government agencies take into account several factors, including:

  • The amount of control the employer may exercise over the details of the work being performed;
  • Whether the worker is engaged in an occupation or business that is distinct from that of the employer;
  • Whether the work is usually done under the employer’s direction or by a specialist without supervision;
  • Whether the employer or the worker supplies the tools;
  • The duration of the worker’s employment;
  • The method of payment (i.e., in regular periodic intervals or upon the completion of the job); and
  • The degree of skill required of the worker.

None of these factors is automatically determinative; however, the courts often give great weight to whether the employer has a substantial amount of control over the worker’s activities. This also can impact whether the employer is liable for torts committed by the independent contractor.

If an employer desires to hire an individual as an independent contractor, the employer may take actions to minimize the risk that the relationship will be re-characterized as an employer / employee relationship. First, the employer should enter into a written agreement with the contractor. This written agreement should specify that the worker is an independent contractor and is solely responsible for payment of employment taxes, withholding of income taxes, and provision of various employment benefits. Second, the employer may require all independent contractors with which it does business to organize a corporation or limited liability company. Third, the employer should attempt to pay the contractor by the job and avoid lengthy relationships. Though it is not possible to guarantee success, by taking these actions, the employer can significantly reduce the risk of having its employment relationships re-characterized.

The information you obtain at this site is not, nor is it intended to be, legal advice. You should consult an attorney for individual advice regarding your own situation.