1099 vs. W-2: Should You Classify as ‘Independent Contractor’ or ‘Employee’?

During the hiring process, a crucial decision for an employer is whether to bring on a new individual as an employee or as a contractor. Granted, in some businesses the choice may be clear, but in others it can require more of a judgment call. This decision is not a small one—it has legal consequences if you get it wrong, as well as a lot of tax ramifications for the newly hired employee or contractor.

The Pros and Cons of ‘Employee’ Classification

The pros of bringing someone on as an employee are all about risk management and control over the work. It’s less risky to classify someone new as an employee because this new hire will be covered by the employer’s workers’ compensation insurance and unemployment insurance. In general, there’s no harm from a legal standpoint in giving the employee more protections as long as the employer is meeting all of their legal obligations (such as overtime pay) in the process.

Additionally, when hiring someone as an employee, the employer has much more direct control over how and when the work gets done. In fact, the employer can direct every aspect of the work flow—which is not the case when using independent contractors.

There are, however, potential downsides for employers when they classify new hires as employees. Most of these revolve around administrative burdens and costs. Administrative considerations include new hire paperwork, processing payroll, and withholding taxes on behalf of the employee. Hiring someone as an employee also typically incurs a lot more cost, such as:

• Paying for the employee’s benefits;
• Paying the employer’s portion of income taxes;
• Paying overtime (which may not always be required for independent contractors—even those who are paid on an hourly basis); and
• Paying for tools, equipment, training, travel, workers’ compensation insurance, and all other associated costs with a new employee.

All of these extra expenses are one of the reasons employers are often tempted to classify a new employee as an independent contractor—even if it isn’t the appropriate classification.

The Pros and Cons of ‘Independent Contractor’ Classification

Bringing someone on as an independent contractor has its own set of pros and cons. The biggest pros are the direct opposite of the cons to hiring someone as an employee—namely, it’s simpler from an administrative standpoint, and there are fewer tax considerations and other costs to worry about.

However, there are also downsides. One of the biggest cons to hiring someone as an independent contractor is the risk that the individual is misclassified. If the individual was hired as a contractor but doesn’t meet Internal Revenue Service (IRS) guidelines for such a classification, the employer may be liable for penalties, back overtime pay, and more.

There is also the risk that the individual may feel slighted if they wanted to be an employee but instead got classified as an independent contractor. This means they would be liable for their own tax withholding and would have to pay a much higher tax rate.

Last but certainly not least, a disadvantage in hiring a contractor is that the employer cannot control every detail of how the work gets done. The employer can only control the end result, not the means. Doing otherwise may void independent contractor status, which is not always a problem; it’s merely something to consider if a high degree of control is desired or required by the employer.

It’s important to remember that this decision is not simply a matter of preference for the employee or employer. It’s a legal matter from the perspectives of both the Department of Labor (DOL) and the IRS. The IRS looks at the degree of everyday control, as well as the degree of financial control, an employer has over an individual’s situation, and more.[i]

Intentionally misclassifying an employee as an independent contractor (or even doing so inadvertently when there was not a good reason for the classification) can result in IRS penalties. The employer becomes liable for all of the taxes that should have been withheld for the employee, plus interest and penalties. Willful refusal to withhold and pay employment taxes can even lead to jail time in some cases. Be sure to understand the guidelines that outline which classification is appropriate for your situation.

This article does not constitute legal advice. Always consult legal counsel with specific questions.

[i] http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Independent-Contractor-Self-Employed-or-Employee

About Bridget Miller:

Bridget Miller is a business consultant with a specialized MBA in International Economics and Management, which provides a unique perspective on business challenges. She’s been working in the corporate world for over 15 years, with experience across multiple diverse departments including HR, sales, marketing, IT, commercial development, and training.