From ride-hailing apps to the rise of mobile delivery services, many self-employed Americans have turned to the gig economy in the past decade to pursue a career, with 36% of employed individuals classifying themselves as independent workers — equal to about 58 million Americans. That number is likely to increase, with the number of U.S. contract employees expected to grow exponentially by 2028 to over 90 million.
As the number of independent professionals rises, it’s important to understand how your business can benefit from working with self-employed contractors and, more importantly, how to classify them to the Internal Revenue Service (IRS).
CO— consulted with U.S. Chamber of Commerce Tax Counsel, Tax Policy expert Sarah Hoyt Corrigan to break down this issue for small businesses.
What is a 1099 independent contractor?
Independent contractors or freelancers are also known as “1099 independent contractors,” which comes from the tax form that is filed with the IRS at the end of the year. As self-employed workers, businesses are not legally required to provide 1099 independent contractors with benefits or add them to their payroll since they are not technically employed by the organization. Instead, 1099 independent contractors are generally brought onto a team for a short period to assist with a specific task or specialized project.
What is the difference between W-2 employees and 1099 independent contractors?
The line between a W-2 employee and a 1099 independent contractor may seem blurry, but the most important difference is whether your business must withhold taxes from a worker's payments.
If you classify a worker as a W-2 employee, you are required to withhold Social Security tax, income tax, Medicare tax, and any state income taxes for the benefit of the employee. If you classify a worker as a 1099 independent contractor, they are responsible for paying federal and state taxes themselves.
The IRS generally applies common law in the following guidance to help companies differentiate between the two types of workers and properly classify them. The IRS directs employers to examine the relationship between the worker and the business and each factor generally falls into three categories—Behavior Control, Financial Control, and Relationship of the Parties.
In most cases, a worker generally should be classified as a W-2 employee if:
- You (the business owner) control the details of how the work is performed.
- You control the business aspects of the worker’s job (e.g., how the worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.).
- You provide office space, equipment, and supplies for the worker to complete tasks (note: remote workers will continue to be treated as W-2 employees if the employer can control what will be done and how it will be done).
- You provide employee benefits, such as insurance, retirement plans, or vacation time.
Workers generally should be classified as 1099 independent contractors if:
- They control when and how they perform their work.
- They use their own equipment and supplies to complete tasks.
- They provide services to several different clients who pay them directly for their work.
Hiring a W-2 employee vs. a 1099 independent contractor
The advantages of hiring a W-2 employee
W-2 employees are hired by a company for an indefinite period of time with the intent that they will remain on the team long-term. They are required to meet the company’s standards to maintain employment, giving employers more control over when and how work is produced by the staff, and the tools they use.
The disadvantages of hiring a W-2 employee
Businesses are required to provide more resources to W-2 employees than they are 1099 independent contractors, including tools, training, and onboarding, and they must cover business expenses on behalf of the employee. This can lead businesses to pay more per employee than they anticipated.
The advantages of engaging a 1099 independent contractor
Independent contractors generally operate on a short-term contract, assisting companies with specialized projects before moving on to other clients. They offer businesses advanced skill sets without having to go through the entire hiring process — perfect for businesses that need temporary expert assistance at an affordable price. They may also provide their own tools and generally don’t require extensive training, saving company resources.
As the gig economy grows, it’s becoming increasingly important to correctly classify your workers.
The disadvantages of engaging a 1099 independent contractor
Companies have less control over when and how work is produced by independent contractors, as these workers have the right to set their own schedule and sometimes may use whatever tools they wish to get the job done. For businesses that have specific work processes and procedures, utilizing a 1099 independent contractor may lead to inadequate results for their needs.
If you’re unsure how to classify your employees, you can file a Form SS-8 to the IRS. They will review the nature of the relationship between the employer and the employee and give you an official determination.
What are the penalties if you misclassify employees?
Across all industries, between 10% and 30% of employees — roughly several million people — are misclassified as 1099 independent contractors every year. Classifying employees as independent contractors means a company can avoid paying Medicare, Social Security, overtime, unemployment compensation, workers’ compensation, and various employee benefits ranging from vacation pay to retirement plans.
Employers who are caught misclassifying their workforce face hefty fines and penalties, which is why it is crucial to correctly classify your employees. The penalties for misclassifying employees vary based on whether the IRS determines the error was unintentional or not. If your business makes an honest mistake and classifies a W-2 employee as a 1099 independent contractor, you may face penalty (and interest) for every W-2 the employer failed to file correctly.
If the IRS determines you intentionally misclassified employees, it can impose additional fines and penalties, such as paying 100% of both the employer and employee’s share of FICA taxes. The IRS may also charge criminal penalties of up to $10,000 per misclassified worker and impose up to five years in prison.
The government takes employee misclassification seriously, especially with underreported tax liabilities representing 80% of the country’s gross tax gap in the United States.
Protecting your business from misclassification penalties
Misclassifying an employee impacts both the employer, who could face legal ramifications, and the worker, who loses access to an abundance of protections and benefits they are owed. Because an employer does not supplement the taxes from 1099 independent contractors, they incur additional tax responsibilities and must pay more out of pocket. However, an unsuspecting misclassified employee may not be aware of these tax responsibilities, leading to financial surprises or inaccurately filed returns.
If you’re unsure how to classify your employees, you can file a Form SS-8 to the IRS. They will review the nature of the relationship between the employer and the employee and give you an official determination. This process can take several months to complete, but it may be worth the wait if you want to hire many workers with the same roles and responsibilities.
If you need to quickly determine your workers’ classification, consult with an employment attorney or tax professional before making your final decision. They’ll work with you to ensure your new worker is properly classified and review contracts to determine they are following local and state laws. It is important to note that the U.S. Department of Labor (DOL) and Federal Fair Labor Standards Act provide a different set of rules and guidance on the definition of an “independent contractor” and “employee.” Most of the time, companies will treat a worker as an “employee” or an “independent contractor” for both IRS and DOL purposes but you must apply the rules separately to make your determination. Notably, if the DOL changes its rules regarding employee classification (as expected in March 2024), such rules do not affect a worker’s classification for tax purposes with respect to the IRS.
Remain in compliance by regularly conducting internal employee misclassification audits and drafting standardized independent contractor agreements to ensure all your gig workers are on the same page about expectations and payment details.
Is a W-2 or 1099 independent contractor better for your business?
W-2 employees are beneficial to businesses that operate on specific processes and are looking to commit to an employee’s growth for an extended period. These employees are going to be more dedicated to the business long-term and will require more extensive training and resources; however, their work will be more tailored to your business needs.
For companies looking for assistance with a one-off project, enlisting a 1099 independent contractor is a cheaper and more efficient solution than hiring another employee, as they offer a valuable and specialized skill set that many teams don’t have readily available and can be brought in on an as-needed basis.
CO— aims to bring you inspiration from leading respected experts. However, before making any business decision, you should consult a professional who can advise you based on your individual situation.
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