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Classifying Your Employees: Distinguishing Between 1099 and W2 Workers

By Ms. Elizabeth Rice, SPHR

With contract employment on the rise, an increasing number of businesses are hiring specialized workers on a contingent basis in order to help with completion of a project, or to fill in for an absent employee. These contract assignments can last anywhere from weeks to years at a time. While bringing in contract employees can provide businesses with some much-needed relief during projects or busy seasons, it can also raise confusion when it comes to classifying them for tax purposes. IRS fines and penalties for incorrectly classifying employees are steep, but can be avoided by knowing the differences between employee classifications.

In keeping with this month's focus on taxes and worker classification, Innovative Employee Solutions® interviewed Matt Bradvica, managing director of tax services for RSM McGladrey, about the differences between 1099 and W2 employees, and the importance of identifying them correctly.

What defines a 1099 or W2 worker?

The easiest way to avoid employee classification errors is for employers to maintain a clear understanding of the factors that determine an employee's status as 1099 or W2, and the differences between the two. According to Bradvica, an easy way to determine the appropriate status of a worker is that "a 1099 employee has a contract with a very specific end date. The worker is free to set their own schedule, and is only responsible for completing the project by the date specified in their contract." On the other hand, "a W2 employee has a set schedule of work hours managed by the employer and has no specified end-date of employment." Essentially, a 1099 employee is paid on a project basis, whereas a W2 employee is paid based on hours worked. Other more specific differences between 1099 and W2 employees are laid out in the IRS' 20-point guide for determining employee classification: (click here to read the full list).

The penalties of misclassifying workers

If an employee is incorrectly classified, the ramifications can be severe. As Bradvica points out, "the fine for an intentional misclassification can be a penalty equal to 100% of the amount in taxes owed. In cases where an employer negligently reports or under-reports employee status, the IRS can impose a 20% accuracy-related penalty."

Correcting classification errors

If an employer realizes he or she has been misclassifying employees, there is no need to panic, but corrections should be made as soon as possible. "The best thing to do is make the changes going forward," Bradvica advises. Companies should also be aware of the potential for audits and prepare accordingly. "In the last few years," Mark says, "the IRS has been very aggressive about payroll taxes. Audits can be prompted by disgruntled former contract employees who feel they have been misclassified and decide to file a complaint."

The confusion of classifying workers in accordance with IRS standards can also be avoided by hiring an outside company such as Innovative Employee Solutions® to act as the legal W2 employer of contract workers. Bradvica points out that this process is "a huge benefit to companies, because of the many questions and confusion surrounding classification. One of a company's worst fears should be tax risks, and by outsourcing payroll for contract workers, you mitigate that risk."

About the author:
Ms. Elizabeth Rice, SPHR is the President of Innovative Employee Solutions® - a San Diego-based company specializing in payroll and HR administrative services for the contingent, non-core workforce. Ms. Rice has more than 20 years of experience in HR and executive management and is noted both regionally and nationally for her particular expertise in employee relations, women's workforce issues, and temporary employment. Ms. Rice can be contacted at erice@innovative-es.com

About RSM McGladrey
RSM McGladrey is a business services firm offering mid-sized companies business and tax consulting, wealth management, retirement resources, payroll services and corporate finance. The company is a part of RSM McGladrey Business Services, an H&R Block wholly owned subsidiary providing accounting, tax, consulting and professional services to mid-sized businesses, primarily through its business units: RSM McGladrey, RSM McGladrey Retirement Resources, RSM EquiCo and MBS. These organizations work together fulfilling their strategy to offer clients a greater breadth of business services as well as bring them closer to the goal of being clients' full-services business advisor.