Payroll is the act in which an employer pays their employees. Payroll includes salaries, wages, deductions, bonuses, and net pay. Typically, payroll will be on a weekly, biweekly, or monthly schedule.
August 09, 2021
1099s and W-2s are payroll forms given to independent contractors and employees, respectively. And it can be confusing to understand how to correctly classify your workers. The distinction is important, whether your workers are independent contractors or employees will affect how both they and you are taxed.
For example, withholding is not required for independent contractors, who provide the company with a Taxpayer Identification Number (TIN). Independent contractors pay both the employee and employer social security/Medicare taxes as self-employment taxes.
The primary way an individual qualifies as an employee or independent contractor is the common law test and ABC test. Each state used a different standard, which is outlined in the table below.
|W-2 Employee||1099 Independent Contractor|
|Required to comply with employer's instructions about when, where, and how to work||Sets own hours; determines own sequence of work|
|Works exclusively for the employer||Can work for multiple employers; services available to the public|
|Hired by the employer||Is self-employed|
|Subject to dismissal; can quit without liability||A contract governs how the relationship can be severed|
|Has a continuing relationship with the employer||Works by the job|
|Work done personally||Permitted to employ assistants|
|Performs services under the company's name||Performs services under the worker's business name|
|Paid a salary; reimbursed for expenses; participates in company's fringe benefits programs||Payment by the job; opportunity for profit and loss|
|Furnished tools, equipment, materials and training||Furnishes own tools, equipment, materials, and training; substantial investement by worker|
|If an outside salesperson: company provides leads, set terms and conditions of the sale, assigns a territory, and controls the sales process||Controls the sales process and terms|
In applying the common law test, IRS examiners must consider three categories:
However, exceptions do allow a worker qualifying as an employee under the common law test to be classified as an independent contractor when meeting the requirements of the reasonable basis test.
Under the ABC test, a worker is by default considered an employee. To be classified as an independent contractor, the hiring entity must satisfy all three of the following conditions:
The ABC test is considered stricter and more concrete than the Common Law Test. The following table is a list of U.S. states and applicable classification test.
|Colorado||A&C of ABC Test|
|District of Columbia||Common Law|
|Idaho||A&Cof ABC Test|
|Montana||A&C of ABC Test|
|New Hampshire||ABC Test|
|New Jersey||ABC Test|
|New Mexico||ABC Test|
|New York||Common Law|
|North Carolina||Common Law|
|North Dakota||Common Law|
|Oklahoma||A&B or A&C of ABC Test|
|Pennsylvania||A&C of ABC Test|
|Puerto Rico||ABC Test|
|Rhode Island||ABC Test|
|South Carolina||Common Law|
|South Dakota||Common Law|
|Virginia||A&B or A&C of ABC Test|
|West Virginia||ABC Test|
|Wisconsin||A&C of ABC Test|
|Wyoming||A&C of ABC Test|
IRS penalties for unintentionally misclassifying an employee as an independent contractor penalties levied can be the following:
The IRS uses several different programs in trying to detect worker misclassifications:
IRS’ Voluntary Classification Settlement Program (VCSP) permits employers to voluntarily reclassify workers as employees for federal employment tax purposes and obtain relief similar to that obtained in the current Classification Settlement Program (CSP). The program applies to employers that are currently treating their workers (or a class or group of workers) as independent contractors or other non-employees and want to prospectively treat the workers as employees. To be eligible, an employer:
Employers that participate in the VCSP will agree to prospectively treat the class of workers as employees for future tax periods.
The gig economy is the labor market that’s made up of freelance and short-term contracts versus a permanent job. The gig economy makes up approximately a third of the U.S. workforce and is quickly growing. Classification of workers in the gig economy, especially those that work on Vertical SaaS platforms such as Doordash, have come under increased regulatory scrutiny in recent years. Primarily, companies are incentivized to classify their workers as independent contractors due to the tax and benefits saving potentials.
While every scenario is different, gig economy, staffing, and EOR companies have some of the toughest decisions in regards to classifying workers. Here’s one passage shared by the IRS to keep in mind:
"You are not an independent contractor if you perform services that can be controlled by an employer (what will be done and how it will be done). This applies even if you are given freedom of action. What matters is that the employer has the legal right to control the details of how the services are performed."