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The relationship a business has with its employees is quite different compared to its relationship with independent contractors.
There are a couple of ways to look at this question. IRS rules are fairly clear, but there are also employment laws on the matter. This article will comment largely on the tax side of this question.
The relationship a business has with its employees is quite different compared to its relationship with independent contractors. Distinct advantages and disadvantages exist for both options depending on the type and amount of work that is desired to be accomplished.
Behavioral Control
One of the big differences that the IRS dictates between an employee and an independent contractor is behavioral control. If the employer trains and directs the work, including hours of work, what tools or equipment to be used, where the work is to be done, specific tasks to be performed, and how the work is to be done, the worker is probably an employee. If the worker can set his or her own hours and works with little or no direction or training, he or she is probably an independent contractor. In short, an employer has a lot more control over employees while independent contractors have a lot more independence in how they accomplish the tasks given to them.
Financial Differences and Control
The financial treatment of both parties is also very different. Factors such as the extent to which the worker has unreimbursed business expenses, the extent of the worker's investment in the facilities or tools used in performing services, the extent to which the worker makes his or her services available to the relevant market, and how the business pays the worker are all major factors to determine whether a worker is an independent contractor or employee.
When the worker gets paid is also different depending on if they are an employee or an independent contractor. An employee has a regular payment schedule that usually ranges between once a week to once a month and is paid at an hourly rate or salaried amount. Independent contractors can work at rates of per hour, day, week, or be paid one amount for the completion of the job.
Regulation and Benefits
A considerable difference between employees and independent contractors is that employees have various federal and local statutes and policies related to employment and labor that protect them and govern how they work. Independent contractors are not governed/protected by the same employment and labor laws.
Depending on the position they hold, employers often offer benefits to employees that independent contractors do not have access to. These benefits include pension plans, insurance, sick pay, and vacation pay. These benefits, along with payment plans such as 401Ks, can incentivize employees to stay with the company for long periods of time and increase satisfaction of the workers. When considering which you should hire for your business, benefits are an element to keep in mind.
Type of Relationship
The type of relationship can help determine if a worker is an employee or an independent contractor. If the worker is doing work that is a primary, ongoing function for the business, that worker should be an employee. Employees should be treated with a sense of longevity while independent contractors on a more situational basis, work that will mostly not be overseen directly by the employer.
What is the worst thing that can happen?
If you misclassify what should be your W2 employees as 1099 independent contractors, you are opening yourself up to a potentially significant liability. The IRS and other various state tax agencies will reclassify what you have paid to your independent contractors as wages and will make you responsible for all unpaid payroll taxes. They will most certainly tack on penalties and interest, they can go back several years and demand everything immediately.
I have seen firsthand a situation where a local construction company chose incorrectly and was handed a tax bill in excess of $100,000 by the IRS for their violation. They soon went out of business - there have been many others caught in the trap of this business killing mistake.
Conclusion
If you are going to pay anyone as an independent contractor, please make 100% certain your decision will be compliant. Is it really a risk worth taking if it could put you out of business?
If you need help navigating the IRS compliance for your business, we are happy to help.
The link to IRS website with supporting documentation below.
