August 9, 2021

How to classify your worker

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.

Common Law Test

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:

  1. Behavioral control: The right to direct or control the means by which the worker performs the work to be done (includes instructions and training provided by the employer)
  2. Financial control: Whether the worker has the opportunity to make a profit
    or suffer a loss
  3. Relationship of the parties: How the worker and the employer perceive their relationship (Form W2)

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.

ABC 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 worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact;
  • The worker performs work that is outside the usual course of the hiring entity’s business;
  • The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.

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.

State Test
Alabama Common Law
Alaska ABC Test
Arizona Common Law
Arkansas ABC Test
Louisiana ABC Test
Louisiana ABC Test
Colorado A&C of ABC Test
Connecticut ABC Test
Delaware ABC Test
District of Columbia Common Law
Florida Common Law
Georgia ABC Test
Hawaii ABC Test
Idaho A&Cof ABC Test
Illinois ABC Test
Indiana ABC Test
Iowa Common Law
Kansas ABC Test
Kentucky Common Law
Louisiana ABC Test
Maine ABC Test
Maryland ABC Test
Massachusetts ABC Test
Louisiana ABC Test
Michigan Common Law
Minnesota Common Law
Mississippi Common Law
Missouri Common Law
Montana A&C of ABC Test
Nebraska ABC Test
Nevada 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
Ohio ABC Test
Oklahoma A&B or A&C of ABC Test
Oregon ABC Test
Pennsylvania A&C of ABC Test
Puerto Rico ABC Test
Rhode Island ABC Test
South Carolina Common Law
South Dakota Common Law
Tennessee ABC Test
Texas Common Law
Utah ABC Test
Vermont ABC Test
Virginia A&B or A&C of ABC Test
Washington ABC Test
West Virginia ABC Test
Wisconsin A&C of ABC Test
Wyoming A&C of ABC Test

Contractor Misclassification

IRS penalties for unintentionally misclassifying an employee as an independent contractor penalties levied can be the following:

  • For net withholding federal income tax, the penalty assessed is 1.5% of wages paid. This assessment is doubled to 3% if the employer failed to file an information return (Form 1099-MISC) for the worker with the IRS.
  • For not withholding the employee’s share of social security and Medicare taxes, the penalty assessed is 20% of the employee’s share of the tax. This assessment is doubled to 40% if the employer failed to file an information return (Form 1099-MISC) for the worker with the IRS. The employer’s share of social security and Medicare taxes must also be paid.

The IRS uses several different programs in trying to detect worker misclassifications:

  • The 1099 Matching Program targets those individuals who receive only one Form 1099-MISC in any given tax year. A person receiving payments from only one company may well be an employee rather than an independent contractor.
  • IRS also tries to identify individuals who receive Forms W-2 and 1099-MISC from the same employer in one year. This situation often occurs when a business brings back retired employees as independent contractors (for example, as consultants)
  • IRS also uses its regular audit routine to detect improper employment status designations, but too few employment tax returns are examined to make this a valuable enforcement tool.
  • Employment Tax Examination (ETE) Program, the IRS assigns revenue examiners to concentrate on employers suspected of worker misclassification, based on leads from other federal and state government agencies

Contractor Reclassification

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:

  1. Must have consistently treated the workers as non-employees
  2. Must have filed all required Forms 1099 for the workers for the previous three years
  3. Cannot currently be under audit by the IRS
  4. Cannot currently be under audit concerning the classification of the workers by the Department of Labor (DOL) or by a state government agency. An employer that was previously audited by the IRS or the DOL concerning the classification of the workers will only be eligible if it has complied with the results of that audit.

Employers that participate in the VCSP will agree to prospectively treat the class of workers as employees for future tax periods.

  • Will pay 10% of the employment tax liability that may have been due on compensation paid to the workers for the most recent tax year
  • Will not be liable for any interest and penalties on the liability
  • Will not be subject to an employment tax audit with respect to the worker classification of the workers for prior years
  • Will agree to extend the period of limitations on assessment of employment taxes for three years for the first, second, and third calendar years beginning after the date on which the employer has agreed under the VCSP closing agreement to begin treating the workers as employees
  • Backup Withholding: Companies may also be required to backup withhold from payments to independent contractors. A 24% backup withholding tax on nonwage payments is withheld if the payee has failed to provide a Taxpayer Identification Number (TIN) or the IRS has notified the payer that the TIN is incorrect.
  • Taxpayer identification number/name combinations that will be reported on Form 1099-MISC can be verified using the IRS’ TIN Matching System.

Tips for Gig Economy, Staffing, and EOR payroll

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."