1099 vs W2

As more companies choose to outsource portions of their workload to independent professionals, it's important for hiring managers and workers to gain an understanding of the legal distinction between employees and contractors. Penalties for misclassification can be steep. Below you'll find general information about each group, in addition to the IRS's criteria for distinguishing the two groups.

1099 vs. W2
Independent contracting means that you are not a permanent employee of a company. You can work in two ways: 1099 (true independent contractor according to IRS rules) or W2.

Characteristics of a W2 Employee
You work as a W2 employee when your client or an agency places you on their payroll, usually to work on a specific project. The client or agency reports your income to the IRS on a W2 form. As a W2 employee, you receive a regular paycheck from which your employer withholds all federal, state, and local taxes. You file regular state and federal tax returns, just as you would if you were a permanent employee.

In most cases, the employer provides the equipment and office space you need. You may be eligible for some or all of the benefits your employer offers to permanent employees such as medical, life, and disability insurance; pension plans; sick days; paid holidays, etc.

Characteristics of a 1099 Contractor
Working on a 1099 basis means that you are working as a true independent contractor under the IRS rules. You work on a 1099 basis when you are in business for yourself as a sole proprietor or as a corporation. Your clients report the money they pay you to the IRS on a 1099 form. Your clients typically contract with you to work on a specific project. You should have a written contract with each client that delineates the work you will perform, the fees the client will pay, and how the client will pay you. You will send invoices to the client in accordance with the contract terms.

True independent contractors are responsible for tracking all business expenses and income and for making quarterly federal and state income tax payments.

The IRS has a series of questions it asks to "test" whether an individual is considered an employee or an independent contractor.

THE IRS CONTROL TEST
Common law defines an employer-employee relationship as one in which the employer has the right to control the "means and details" by which services are performed. Years ago, the IRS developed what came to be known as the 20-Factor Test, an analytical tool for distinguishing employees from independent contractors. This evaluation method was revised in 1996. The current test evaluates the degree of control according to three criteria: behavioral control, financial control, and the relationship between the parties.

BEHAVIORAL CONTROL
Instructions. If a company gives a worker instructions pertaining to how the work gets done rather than simply to the end product, this is evidence of an employer-employee relationship. The more detailed the instructions, the stronger the evidence. Examples of instructions indicating that a company controls the means and details of the work include:

When and where to work

Which assistants to hire

Sequence of steps to follow

Training. Ongoing training about specific methods and procedures is evidence of an employer-employee relationship. Some kinds of training, however, are consistent with independent contractor status. These include informational sessions about new policies or pertinent government regulations, and voluntary training programs for which workers do not receive compensation.

FINANCIAL CONTROL
Opportunity for profit or loss. The IRS considers the opportunity for profit or loss to be the most significant test of whether a worker maintains control over the economic aspects of his or her activities. An independent contractor has the freedom to make business decisions that impact the profitability of his or her enterprise. Such decisions might be related to the types of equipment to buy, or how to invest capital. In addition, the following factors contribute to the worker's opportunity for profit or loss:

Significant investment. A significant financial investment on the part of a worker, such as the lease of office space, or the purchase of equipment, is evidence that the worker is operating as an independent contractor. Since some types of work do not entail large expenditures, an absence of a significant investment is not necessarily a sign that the worker is an employee.

Unreimbursed expenses. While companies usually reimburse employees for their incurred business expenses, some also reimburse independent contractors. Consequently, the IRS does not consider reimbursed expenses to be an important factor in distinguishing the two groups. The presence of unreimbursed expenses, on the other hand, is taken to be evidence that the worker is an independent.

Services available to the relevant market. If a worker makes his or her services available to other potential clients, this is evidence of independent contractor status. However, a contractor may hold only one contract for a period of time without it constituting an employment relationship, as long as his or her services are available to other companies.

RELATIONSHIP OF THE PARTIES
Intent of the Parties/Written contracts. In determining the relationship between a worker and a company, the IRS considers how the written contract describes the intent of the parties involved. What is important is not the title specified in the contract (contractor or employee), but any evidence of which party maintains control (descriptions of the rights and obligations of the parties, reimbursement of expenses, etc.). Although intent is not considered substantial evidence in itself, it can play a pivotal role in cases where other evidence is ambiguous.

Benefits. If a company grants a worker employee benefits, such as health insurance or paid vacation time, this is evidence of employee status. However, the absence of employee benefits is not necessarily a sign of contractor status, especially in cases where the law does not require a company to offer benefits.

Termination. Traditionally, the terms on which either party could terminate the relationship played an important role in determining whether a worker was an independent contractor or an employee. The ability of either party to terminate at will was taken as a sign of an employment relationship. Because of the complexities of labor law and modern business practices, however, the IRS now gives less weight to this type of evidence.

Ongoing Relationship. If a business and a worker enter into a relationship with the understanding that it will be permanent or indefinite, this is evidence of an employment relationship. However, long-term contracts, as well as contracts that are regularly renewed because of excellent service or competitive prices, are consistent with independent contractor status.

Regular Business Activity. If a worker performs activities or services that are "a key aspect of the regular business of the company," this is evidence of an employment relationship. This does not mean that a contractor cannot perform important, necessary work for a company. It simply indicates that the work cannot constitute one of the company's essential functions. For example, a frozen yogurt shop may hire a contractor to install and repair the yogurt machines. Although this work is essential, it is not part of the company's regular business.

Please note that this information is provided only as guideline. According to the IRS's own publications, there is no "magic number" of criteria that determines whether a worker is a contractor or an employee. In each case, the evidence should be weighed to see which party maintains the predominant control over the means and details of the work. For more information, visit the IRS Web site at
www.irs.gov.