airCFO Tax 101: 1099s and Employee Classification: Part 1
One of the most common mistakes startups make with finance and HR is misclassifying their employees due to misunderstanding how the classifications work. The consequences for misclassification can be severe and create long-term and expensive issues for leadership teams. In this Part 1 of 2 on 1099s and Employee Classifications, we walk through some common errors and why they happen.
“Contractors” are less administratively burdensome and often less expensive than employees because the employer doesn’t have to file all the payroll forms or pay the employer portion of payroll taxes, so employers will often elect to hire workers on as “contractors” even though they should actually be hired as employees.
Employers should keep in mind that contractors have a fundamentally different relationship to the business than employees. The IRS provides a list of factors to help employers differentiate between the two. Some of the factors include how much control an employer has over the job and the nature of the job. If an employer has control over how the job is completed and can control, direct, train, and forbid them from working for competitors, then the individual is really an employee.
Advances in technology have made it possible for employers to hire individuals that fall into a grey area between contractors and employees. There are websites and applications now that allow individuals to sign up to either pay for or provide services. Since startups are often in this software-as-a-service (SaaS) platform space, their contractors and employees are more likely to run in this grey area and therefore they are more likely to make classification errors.
Some states also have different/more stringent employee classification rules than the federal regulations. Possibly the most famous example would be California passing regulation that explicitly makes gig workers employees rather than contractors.
An unfortunate situation new founders can find themselves in can be misclassifying an employee or contractor. With an employee, the employer has to pay Social Security, Medicare, possibly state, and possibly state unemployment. Along with this is the filing of payroll forms such as Forms 941, 940, and W-2s. Not filing these forms in a timely manner can result in penalties along with the cost of the original taxes that should have been paid.
On the other hand, not filing 1099s can result in penalties as well for each form that was not filed correctly. The best way to handle these problems is to proactively ensure that workers are not misclassified to begin with, but the conservative approach is definitely to default to employee rather than contractor if in doubt. If you discover after the fact that you have misclassified someone, we would recommend you correct it going forward rather than file amendments and risk flagging an audit.
Another problem we sometimes see is not collecting the W-9 from contractors before starting to issue payments and then not having sufficient information to fill out 1099s at the end of the year. Best practice is to collect the W-9 before the contractor is paid. If the contractor will not provide a completed W-9, do backup withholding at the highest rate on their payments as that is the most conservative option for the contracting company.
If there is ever a question, ask your accounting or payroll team/company! That is what they (or we) are here for– and we are hopeful that discussing these stressful and often-misunderstood administrative elements of running a business can shed light on what is often an overlooked area. In Part 2 of this series, we will be addressing the specific management of 1099s and advice for and trends around structuring for companies by the stage of their growth.