1099 Versus Employee

By far, the one seminar or workshop I present to any audience that gets the best feedback is the one entitled “1099 versus Employee.” Especially at this time of year, when business owners are preparing to sit with their CPA or bookkeeper. “1099” refers to IRS Form 1099 and is the shorthand term for an Independent Contractor doing work for a business but not being paid as an employee of said business.

The IRS has given guidelines to its agents to help determine worker status. In the past, a list of 20 factors compiled by the IRS had been used in court decisions to determine worker status. The list, sometimes called the “20 Factor Test,” is still used as an analytical tool, although some of the factors are no longer as relevant as they once were. Recently, agents are directed to focus on the overall situation rather than to emphasize one or two of the 20 factors. This has, in essence, increased the chances of gray areas and also increased the chance the IRS will find something an employer has done wrong resulting in penalties and interest. Many business owners and their accountants feel the IRS has done this on purpose because Federal and State government agencies receive far less in tax revenues from companies using 1099s.

The determination of whether a worker is an employee or an independent contractor is based on common law rules that look at the relationship between the worker and the business, taking into consideration all evidence of control and independence. The determination of worker status depends on several factors, including: the extent to which the person receiving the services has the right to direct and control the service provider on what is to be done and how it is to be done. An employer generally has the right to control how an employee performs a service. In contrast, independent contractors determine for themselves how the work is to be performed.

Courts consider various factors in determining worker status. These factors fall into three main categories: behavioral control, financial control, and the parties’ relationship to each other. These factors are used in connection with IRS audits concerning worker status. Not all factors need to be present in any given situation, and no single factor is a sole determinant.

Behavioral Control

Factors that may show whether a business has a right to direct and control how the worker does the task for which the worker is hired can include, but are not limited to, the type and degree of:

  • Instructions. An employee is generally subject to the business’s instructions about when, where, and how to work. Even if no instructions are given, sufficient behavioral control may exist if the employer has the right to control how the work results are achieved.

  • Training. An employee may be trained to perform services in a particular manner. Independent contractors ordinarily use their own methods.

Financial Control

Factors that may show whether the business has a right to control the business aspects of the worker’s job can include, but are not limited to:

  • The extent to which the worker has unreimbursed business expenses. Independent contractors are more likely to have unreimbursed expenses than employees. Fixed ongoing costs that are incurred regardless of whether work is currently being performed are especially important. However, employees may also incur unreimbursed expenses in connection with the services they perform where they work.

  • The extent of the worker’s investment. An independent contractor often has a significant investment in the equipment he or she uses in performing services for someone else. However, a significant investment is not required for independent contractor status.

  • The extent to which the worker can realize a profit or incur a loss. Having the possibility of incurring a loss indicates the worker is an independent contractor.

Type of Relationship

Factors that may show the type of relationship between parties can include, but are not limited to:

  • Written contracts describing the relationship the parties intended to create and how the parties actually work together.

  • Whether the business provides the worker with employee type benefits, such as insurance, a pension plan, vacation pay, or sick pay.

Intentionally misclassifying an employee could result in the employer paying both sides of the tax equation involved with payroll – simply put:

  • The full amount of Federal and State income tax that should have been withheld from their employee plus penalty and interest.

  • The full amount of both the employer and employee shares for Social Security and Medicare plus penalty and interest.

  • ALL Federal and State Unemployment contributions that should have been made based on the employees pay plus penalty and interest.

In other words, the employer is responsible for his tax liability plus what he was responsible for withholding from his employee.

That is a staggering scenario for any business owner to face down and the very reason why “1099 versus Employee” is such a popular seminar.

Robert Sherlach is the Hudson Valley Manager for GTM Payroll Services, a national payroll, human resource, and time and attendance management company. He can be reached at R.Sherlach@gtm.com.