Workers in the United States can be classified as W2 employees or 1099 independent contractors.

1. Independent Contractors

An independent contractor is someone who works independently as a consultant for a single or multiple clients.

They set their own hours, work using their own equipment, and the nature of their work is not controlled, as such, by the company that they work for. For the projects that are executed by independent contractors, companies cannot dictate their terms in terms of how their work ought to be completed.. Independent contractors themselves determine the best way to get the work done and deliver results to the company with which they work. They can even work on multiple projects at the same time, with several different companies.

Companies usually pay independent contractors a fixed price for projects or an hourly rate. Fixed price projects are usually paid in milestone installments as the project is completed. On the other hand, hourly wages are paid after the contractor enters their hours worked every week for the projects that they are completing. Companies operating within the United States are not required to withhold Federal, State, Medicare, or Social Security taxes from the pay of these independent contractors. Independent contractors are not offered any health insurance, retirement, or unemployment benefits since they are completely independent of the company with which they work.

2. W2 Employee

A W2 employee can be a part-time or a full-time employee of a company. A worker is classified as a W2 employee when the company with which they work has control over the type of work they do, their work timings, and provides the necessary equipment to the employees to perform their duties and responsibilities.
In this case, companies are responsible for withholding Federal, State, Medicare, and Social Security taxes from the pay of their employees. Companies that hire W2 employees are also required to pay payroll taxes to the government. W2 employees are entitled to unemployment benefits if they are laid off by the company, and in most cases, get a severance package in the case of their termination. For these reasons, W2 employees typically turn out to be more expensive for companies in comparison to independent contractors. Companies generally spend 30% in fringe benefits over and above what they pay their W2 employees.

Tax Process for W2 vs 1099 Independent Contractors

Independent contractors submit a W9 form when they begin work for a company and receive a 1099-MISC tax form at the end of the tax year. This form describes their pay throughout the year, and they are required to use this form to file their taxes with the government. Furthermore, independent contractors are able to claim expenses pertaining to the projects that they complete as tax deductibles. For example, if they commute to the client site, or work from home on their laptop, or use their phone to conduct work, they can classify these expenses as “work related” and thereby reduce their taxable income.
W2 employees complete a W-2 form when they begin employment with their employer. Details on this form are used to determine how much tax is withheld from their paycheck. At the end of the tax year, employees are sent a W9 form that they use to file taxes with the IRS. There are hundreds of companies that provide payroll services to companies to help them manage their W2 employees.

Misclassification

Companies often tend to misclassify workers as independent contractors when they should, in fact, be classified as W2 employees. There are certain tests a company can use to figure out how to correctly classify their workers:

1. Behavioral

If the company has significant control over the nature of work that is performed by the worker, their work timings, location and the equipment they use, workers should be classified as a W2 employee.

2. Nature of Business

If the worker performs work for a company that defines the business of the company, the worker may be classified as a W2 employee. However, there are no clear rules of engagement on this front, and the laws are not very clear. For example, drivers for Uber provide transportation services and Uber is classified as a transportation provider. In this case, Uber drivers may be classified as a W2 vs 1099 independent contractor. Different states have different interpretations of this, and it is still not completely clear what the law requires.

The IRS does not have a clear-cut way to figure out which worker should be classified as a W2 vs 1099 independent contractor. Therefore, this classification is very subjective and varies from company to company.

Penalties for Misclassification

Companies can be penalized if they are found to have misclassified their workers as independent contractors. Penalties can include:

  • Payment of all taxes that were not withheld / paid for independent contractors, such as Federal, State, Medicare, Social Security, and Unemployment taxes.
  • Providing insurance and retirement benefits to their employees going forward.
  • Providing workers’ compensation insurance benefits to employees going forward.
  • Any other penalties as determined by the IRS.
  • Payment of all taxes that were not withheld / paid for independent contractors, such as Federal, State, Medicare, Social Security, and Unemployment taxes.
  • Providing insurance and retirement benefits to their employees going forward.
  • Providing workers’ compensation insurance benefits to employees going forward.
  • Any other penalties as determined by the IRS.

Rise in Independent Contractors

The United States is experienced a boom in independent contract or freelance work. According to the Freelancer’s Union, there are about 57 million workers in the US who freelanced in some capacity in 2018 which makes up a third of the US workforce! Studies conducted by the Freelancer’s Union and UpWork estimate that by 2027, more than 50% of the US workforce will freelance in some capacity.

SkillSoniq is a new type of digital marketplace that connects companies with skilled, local freelancers in the same city. All the freelancers on SkillSoniq are “contract to hire” which means companies have the option to first try them out as a 1099 independent contractor and then offer them a full-time job if a good mutual fit is determined. You can learn more about the contract to hire model here. Currently, SkillSoniq operates in New York, which is the largest market for skilled freelancers in the United States.

Share