Worker Classification and Why It Matters

Worker Classification and Why It Matters

Did you know the IRS can assess penalties for misclassifying what they would consider a W-2 employee as a 1099 Contractor or vice versa? To avoid this type of conflict it is important to understand the difference between the two while you are looking for help on the job.

Generally, an employee is an individual with whom you hire to perform services in which you can control their daily functions such as the job they do and how the job will be done. Contractors, on the other hand, must carry a high level of independence, controlling their own schedule and how the job will be performed. It is important to reference both local and federal guidelines and perform all applicable tests to solidify your decision on which category your potential new hire falls into. The Department of Labor provides an economic realities test which includes seven major factors, listed below, to assist in making your determination. The Department of Labor weighs each factor equally and all factors should be taken into consideration while analyzing the relationship. Similarly, the IRS has three common law rules: Behavioral Control, Financial Control, and Type of Relationship which categorize the seven factors mentioned below.

Under Behavior Control, if the employer has the right to control, direct, train, and provide instruction to an individual, the relationship is classified as an employee.  The three factors used to analyze Behavior Control are as follows:

  1. Integral part of the business
  2. Nature and degree of worker’s control over the work
  3. Amount of contractor’s initiative, judgment, or foresight

The analysis of Financial Control is another factor used to assist in determining the status of a new relationship. Unlike employees, contractors are expected to provide their own team, equipment, and items necessary to complete the job at hand. Contractors could lose money or make a profit on jobs while employees do not assume that risk.  Factors used to analyze Financial Control are:

  1. Investment in facilities and equipment
  2. Worker’s opportunity for profit or loss

Lastly is the analysis of the Type of Relationship you have with the individual. A relationship lasting longer than the duration of a project is considered more of an employee relationship. If an individual is performing key activities for the company along with receiving employer provided benefits this typically establishes an employee relationship.  Factors used to analyze Type of Relationship are:

  1. Permanency of the Relationship
  2. Degree of independent business organization & operation

The Department of Labor was set to consolidate their seven factor economic realities test to two core factors effective March 4, 2021. However, with the change of presidency, a Regulatory Freeze was placed on the update delaying it until May 7, 2021. The two core factors would focus on:

  1. The nature and degree of control over the work.
  2. The worker’s opportunity for profit and loss based on initiative and/or investment.

It is important to review the local and federal laws in your area to assist with the determination of the relationship you will be establishing with your future employee/contractor.

Please note there are no set number of factors needed to make this determination, and the IRS suggests that you document and substantiate your decision. At the end of each year, you must issue a tax form W-2 to your employees and a tax form 1099 to independent contractors who perform more than $600 of services. Our firm is equipped with QuickBooks Pro Advisors who can assist with these filings.

“Final Rule: Independent Contractor Status under the Fair Labor Standards Act.” U.S. Department of Labor Seal, www.dol.gov/agencies/whd/flsa/2021-independent-contractor.

“Fact Sheet 13: Employment Relationship Under the Fair Labor Standards Act (FLSA).” U.S. Department of Labor Seal, www.dol.gov/agencies/whd/fact-sheets/13-flsa-employment-relationship.

“Understanding Employee vs. Contractor Designation.” Internal Revenue Service, www.irs.gov/newsroom/understanding-employee-vs-contractor-designation.


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