With an increase in freelancers and independent contractors, many businesses are switching from W2 employees to 1099 contractors. However, it may appear challenging to classify a worker as an employee or an independent contractor for some tasks.
Classifying workers correctly is essential to avoid legal troubles and costs and handle human resource and tax concerns accordingly, especially during tax season. Here, we will talk about the differences between employees and independent contractors and which ones you should hire for your business.
Employees and Independent Contractors: How Are They Different?
Employees are often permanent, salaried workers, while independent contractors work on short-term, one-time projects.
A full time employee is a typical worker who receives a salary and has a long-term contract with your business. The employer has the right to oversee and control the actions of an employee, unlike those of an independent contractor.
An employee receives benefits from the employer, receives more than or equal to the minimum wage, and has their income tax withheld by the employer. An employee focuses on the business they work at instead of having multiple clients like an independent contractor. Companies can fire employees if they see fit.
An example of a benefit an employee may receive is a health benefit. Legally, a company needs to provide health care coverage to its employees if they have more than 50 W2 workers.
An employee is also known as a W2 worker since you need to file a W2 tax form for such a contract.
INDEPENDENT CONTRACTORS (1099)
Independent contractors are self-employed, specialized workers. They provide services to multiple clients at a time and have a written contract for a specific short-term task.
Unlike employees, independent contractors need to arrange the tools and expertise to get a task done. They get to choose when and how to work since they are their own business owners. Independent contractors also need to pay self-employment taxes.
1099 contractors do not receive employee benefits. Companies are also not bound by the minimum wage when hiring an independent contractor. Their agreement stays within the bounds of their contract. The company and the contractor can renew this contract whenever they want.
A 1099 tax form is what an independent contractor needs to fill, which is why we call them 1099 workers.
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How to Classify Your Workers as Employees or Independent Contractors
Despite the clear-cut definitions of 1099 and W2 workers, some companies may struggle to classify workers as employees or independent contractors. For this purpose, the IRS has established a test with three elements to help companies classify their workers.
Behavioral: This involves the degree of control companies have over the worker’s actions. Companies can decide where, how, and with what tools a W2 employee should work but cannot decide the same for an independent contractor.
Financial: What payment method does the company use to compensate the worker? Additionally, who manages the finances of the project? For a W2 employee, the payment method is often a salary, while a 1099 contractor gets a one-time fee. The company manages the economic costs of a W2 worker’s job while the 1099 contractor oversees such business expenses themselves.
Type of Relationship: This pertains to the terms of the employment in the contract. A mere classification is not enough. The length of employment, the pay, and the documentation need to be specific to the type of worker.
A very easy way to determine the classification is to look at the degree of control you have over the worker. If the worker has more independence, they are an independent contractor. If you control most aspects of their work – or if you have the right to do so – they are an employee.
If despite the test, you still want to confirm the classification, you can do it through an SS-8 form filed with the IRS. You can provide them with the details of your contract, and they will determine whether an employee is a W2 worker or a 1099 contractor.
Should You Hire Employees or Independent Contractors? - W2 vs 1099
Both employees and independent contractors have their advantages and disadvantages. You cannot say that one is better than the other because the favorability depends entirely on the company. A company needs to consider their budget, their time, and the number of legal issues they are willing to manage.
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PROS AND CONS OF EMPLOYEES
An employee is often committed to the company, but the business also needs to pay them benefits and payroll tax. This can create issues for a small business.
Commitment: A W2 employee will be completely committed and dedicated to your company. Instead of just completing a specific task, that employee will go the extra mile to benefit your company. An independent contractor often has several other clients, so their level of commitment will be lower.
More control: Unlike an independent contractor, you can control what your employee does, how they act, and what tools they use. This gives you more power over the quality of work you receive. You can even avoid extra costs by hiring an employee since you get to choose the material to use during the task.
Familiarity: Since your employee works for you, they know your quality standards and the kind of work you want. This means that the task done will often be up to your standards. This may not be the case with independent contractors who have their own quality standards.
Continuity: If you need a new task done on short notice or if your priorities change, you can always ask your employees to switch their focus to that task. With 1099 contractors, you have a specific agreement, and they have a particular area of focus.
Not as time-consuming: You can simply delegate long-term responsibilities to certain employees for as long as you want. This will free up the responsibility of dictating every task.
Benefits: When you hire an employee, you will need to pay them healthcare, vacation, and other benefits. You are even required to pay some benefits by the law. This can be costly and time-consuming.
Payroll paperwork: You need to carry out a lot of payroll paperwork for employees. Your accounting department will also have to handle withholding social security taxes and Medicare taxes. This can be time-consuming and hectic.
Legal issues: There are several IRS and CRA regulations attached to employees. You need to make sure to pay them a minimum wage, overtime pay, and benefits. You will need to hire an accountant, preferably a CPA or a lawyer, to help you navigate through these regulations.
PROS AND CONS OF INDEPENDENT CONTRACTORS
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An independent contractor saves you time and legal trouble, but they are less committed to your company and may not have the same quality standards as you do.
Less cost: With an independent contractor, you can save on costs since you do not have to pay them overtime salary, regular stipend, home office expenses and benefits such as: health insurance, unemployment insurance and social contributions.
Specialization: Independent contractors specialize in certain fields and tasks, so their level of expertise and experience will often be favorable. They will do the job well. For example, if you require a data science professional, you can find an independent data science expert.
Low legal risk: You do not need to follow any employee regulations such as workers compensation or benefits with independent contractors. They cannot bring any wrongful termination claims against you either. This will reduce the burden on your HR and accounting departments and will save you legal trouble and cost.
Flexibility: If you have a low or fluctuating budget, you can hire an independent contractor for a very short amount of time. In contrast, you need to continue to pay employees even when you encounter a loss.
Less control: You cannot monitor or control an independent contractor’s methods or performance. This may prevent you from controlling the quality of the work as well.
No commitment or loyalty: An independent contractor is not loyal to your company and will therefore not benefit your brand outside that specified task.
High hourly rates: Independent contractors are self-employed experts, so their rates will often be high and uncertain. You may end up paying more while giving up the benefits of full-time employees.
Uncertainty: A certain independent contractor may do a task excellently, but that contractor is a short-term one. They might not be available the next time you need a task done. You will then need to take another risk and hire someone else.
No promotion: When the contractor does the job, the work will promote their brand, not yours.
Copyright: Unless agreed otherwise, the contractor owns the copyright of the project.
An employee is a worker who stays with you for the long term and upon whom you can exercise a greater degree of control. An independent contractor stays for the short term and works of their own accord.
By hiring an independent contractor, you save time and cost on legal issues and paperwork that you need to do for an employee. However, employees show a degree of commitment and continuity if hired.
If you have an effective tax plan, you offset your tax burden and boost your tax efficiency. Other benefits include reducing healthcare expenses or offering your retirement with contributions.
However, you can only develop a strong tax planning strategy when you start early, not when the year ends. Keep in mind creating a tax plan early will help you save more on your annual income tax.
Monthly tax planning services are a fantastic tool to do this. At Hall Accounting, we have had tremendous success with our monthly clients. Schedule a call today to learn more about this service, and see if it is a good fit for you and your business.