Technological innovations, the evolution of the employer relationship and the rise of the independent workforce are a few key elements that have evolved the workforce landscape. Human resources professionals, executives and hiring managers are confronted with an expanded menu of choices for hiring talent and managing how work gets done. Organizations no longer simply have to find the right person to hire for a job, but now must consider the best workforce model to engage. Increasingly, those discussions involve the decision between engaging identified talent as a traditional W-2 employee or 1099 independent contractor.
Correctly classifying soon-to-be-acquired talent as either traditional employees (i.e., recipients of a W-2 Wage and Tax Statement) or independent contractors (i.e., recipients of 1099 Miscellaneous Income tax forms) can have long term, far-reaching implications, particularly if completed improperly. It is incumbent upon the hiring business to fully understand the advantages, disadvantages, and legal implications of this important step in the talent procurement process.
Though their hourly calculated reimbursement may be significantly higher than those of traditional employees, at the end of the day, independent contractors often actually result in less overall spend. Since independent contractors are responsible for paying the employer and employee portion of FICA earned income taxes, you are not responsible for this costly and administratively time-consuming expense. For a traditional employee, the employer is responsible for paying half of the 12.4% Social Security tax (up to $117,000 in 2014) and half of the 2.9% Medicare tax, which has no upper limit.
In addition to the initial tax savings involved, independent contractors are typically ineligible for employee benefits such as health and worker's compensation insurance, further decreasing the overall spend. As of December 2013, the Department of Labor estimates that benefits are valued, on average, at nearly 31% of salary. Also, as the ACA employer mandate begins to take effect, the number of employees who should be eligible for partially employer-sponsored health insurance coverage will grow considerably.
Flexibility can be a strong determining factor in choosing whether to engage talent as a 1099 vs W2. If your business has seasonal highs or lows, or you require specialized talent for a specific project, you may want the staffing flexibility of 1099 workers. The decision should ultimately hinge on the particular demands of your specific project and business model. In most states (not including Montana), at-will policies allow employers (and employees) to terminate the working relationship at any time for any reason, but an employer's ability to terminate a working relationship with 1099 worker may be governed by your contract with the independent contractor.
Traditional employees offer the flexibility of extensive employer control over how, when, and which projects are completed at any given time. With a W-2 employee, businesses can assign more hours, more personnel, or both to a project in the timeframe of their choice. One benefit of an employee is you can direct and control their day-to-day work, and thus the productivity and use of their time.
With a 1099 worker, on the other hand, employer control over when and how a project is completed must, by definition, remain quite limited. An independent contractor is responsible for how their work is done without direction or control. Using independent contractors on a project, however, offers the flexibility of being able to acquire talent for a circumscribed period of time without an ongoing commitment, financial or otherwise.
Independent contractor misclassification risk is perhaps one of the most misunderstood aspects of the W-2 vs 1099 decision and can also be the most costly. Unless your 1099 workers truly meet the IRS definition of "independent," your business could be financially responsible for substantial fines and penalties. It is vital to carefully review whether your potential worker meets the IRS's three behavioral factors: control, financial risk and relationship between the parties. If an independent contractor does not meet IRS standards, it may be in your best interest to hire as a traditional W-2 employee or to use an intermediary service to engage the contractor. The consequences for failure to do this may far outweigh any temporary financial advantages of permitting a worker who technically meets the definition of "employee" to engage under a 1099.
Finances, flexibility, and foreseeable risk are each important considerations for businesses making W-2 vs 1099 hiring decisions.
It is possible to retain the advantages and minimize the disadvantages of this critical decision by having a defined engagement process. One part of this is staying ahead of the changing regulations regarding misclassification. In an audit situation, intentional misclassification carries far greater penalties, so knowing all the latest in contractor law can protect your company.
Need to know information for any individuals or companies hoping to engage independent professionals in the 21st Century.
MBO Partners developed a calculator that quantifies what we can: the IRS component of the risk. Our legal team scoured the IRS code and assembled the possible penalties into a single easy-to-use calculator.