1099 or W-2: Who’s Working for You?

Claudine Woolf was a successful Mary Kay sales director in 1997, with 50 saleswomen under her and a company car. Then she was diagnosed with breast cancer. During her treatment, her sales dropped off, and she was not able to meet her quotas for the Mary Kay Grand Am, nor even her regular sales quotas. Her request for a temporary reduction in quotas while she pursued her treatment was denied by Mary Kay, and soon she lost her directorship and her car.

When Woolf recovered, she sued Mary Kay on the grounds that they had failed to make adequate accommodations for her while she was disabled, as required by the Americans with Disability Act. Mary Kay's defense was that the law applies to employees, while Woolf, like all Mary Kay sales people, was an independent contractor. In 2002, the court disagreed, saying that Woolf was actually an employee, not an independent contractor, and awarded Woolf $11.2 million dollars, including $10 million for punitive damages.

Woolf's case illustrates the potentially extreme costs of wrongly categorizing someone as an "independent contractor" instead of an "employee". Employees are protected by labor laws that do not apply to contractors, and employers have obligations – like withholding taxes and paying for unemployment and worker's compensation insurance – that they do not have with contractors. Even when you don't have a wrongful termination case on your hands, a simple IRS audit that determines you are wrongly categorizing people as independent contractors who should be considered employees can result in thousands of dollars or more in back payments and penalties.

Determining who is and is not an employee under the law can be frustrating, though. Consider Woolf's case again: a 2006 appeal court decision reversed the verdict and found that Woolf was, indeed, an independent contractor under the law. If even the courts can disagree about how a worker should be categorized, you can imagine how frustrating it can be for a small business person or entrepreneur to feel confident about the status of the people who work for them.

You'd think the IRS would have clear guidelines on this, but alas, they don't. Their page "Independent Contractor (Self Employed) or Employee?" is clear about how unclear this is:

There is no “magic” or set number of factors that “makes” the worker an employee or an independent contractor, and no one factor stands alone in making this determination.

Helpful, right?

There are standards, of course, but they have an awful lot of wiggle room. Basically, someone is considered an independent contractor based on these three criteria:

1. Behavioral control,
2. Financial control, and
3. Type of relationship.

Behavioral control means how much input you have as an employer over the way an employee does his or her job. For instance, when you hire a plumber, you have very little control – you tell the plumber about the problem and he or she figures out what to do and how to do it. Some of the elements that play into behavioral control include:

• Tool ownership. Independent contractors often own their own tools.
• Time management. Independent contractors control how they use their time, and what they do with it.
• Control over work processes. Contractors do their work in the way they see fit, not in a way dictated by an employer.
• The ability to refuse work. Contractors can decide whether or not to take a job, while employees are expected to do whatever work is assigned to them.
• Suppliers. Contractors often source the material they need for a job from third-parties, while employees would be expected to receive their supplies from the employer.

Financial control refers to how an employee is paid and the nature of that payment. Employees are typically paid an hourly wage or a salary, regardless of the amount of work done or the nature of that work. Contractors, on the other hand, are generally paid for the specific work done. Some factors to consider include:

• Expense reimbursement: A worker who is expected to bear the expenses of a job – mileage, extra labor costs, supplies and equipment, special training – is most likely a contractor.
• Regularity of payments: Employees are usually paid on a regular and ongoing basis, while contractors are often paid upon completion of a job or on an agreed-upon payment schedule over the course of the job.
• Exclusivity of employment: Someone who performs similar services for a number of employers at the same time is probably a contractor.
• Ownership of facilities: If a worker performs their job in their own office, warehouse, foundry, or other facility they can likely be considered independent contractors.
• Profit and loss: Contractors earn a profit, or incur a loss, on their work.

Finally, the type of relationship between an employer and worker helps determine the worker's status. Employees typically have ongoing, open-ended relationships with their employers, and may be paid medical benefits or receive pensions, retirement contributions, or stock options. Independent contractors usually have limited relationships with employers, and rarely receive benefits. Things to consider include:

• Duration of employment: While an employee can generally assume he or she will remain employed until they are fired or laid-off or they quit, contractors are often hired with the expectation that the relationship will cease when they have completed a specific job.
• Contractual clauses: Contractors often have detailed contracts spelling out exactly their relationship with their employers. (But a contract that explicitly states someone is an independent contractor may not be enough; Mary Kay's contracts define workers as contractors, which proved insufficient for the first court that heard Woolf's case.)
• Nature of the work: A worker who performs a core function of a business is almost always an employee. Contractors generally perform peripheral tasks like maintenance, marketing, consulting, and so on. This follows from the notion of behavioral control above: a worker who performs a key function for a business is not likely to be given free rein in whether or not they do so or how they do it.

Note that not all of these factors need apply to determine a worker to be an employee or an independent contractor, and none of them are explicitly weighed more heavily than any other.

While by no means foolproof, a general guideline to use when considering how to classify a worker is to consider whether you've hired them to achieve a particular outcome or to follow a specific process. Contractors are generally instructed to reach some outcome – do my taxes, design my logo, print my annual report – and left to their own expertise and resources to determine how best to do so. Employees, on the other hand, are usually given a set of processes to follow – answer the phone and transfer the calls like so, pull this lever whenever the light is on, drive this route, follow this script – as part of an overall workflow.

If you're still not sure, you can file Form SS-8 [PDF link] with the IRS to request their evaluation of a position. Of course, it's the IRS, so you can expect them to take up to six months to make their decision.

It's best to be sure, though, because a miscategorized worker can cost you a lot of money. Someone wrongly categorized as an independent contractor can, for instance, file for payment of his or her back Social Security, which can add up if a worker has been with you for a long time. You may also be held liable for state and federal unemployment taxes as well as payments to your state's worker's compensation program.

If you hire workers as independent contractors, make sure you are absolutely clear with them (and yourself) about why you consider them as such. Don't just hand them a contract and a W-9; make sure they understand why they're getting a W-9 instead of a W-4 and what that means for them, both in terms of their obligations (being responsible for paying their full income tax, paying self-employment taxes, providing their own insurance, etc.) and their rights (for example, their ability to sell their services to multiple employers). Be clear about the terms of the contract and what your expectations are, and don't try to hedge your bets by implying an ongoing relationship that is not dictated by the terms of the contract.

Understand your own rights and responsibilities as well. Although it might often seem smarter to hire people as independent contractors rather than as full employees, realize that you will have less control over the way they do their work and their timetable. If you have a tendency to micromanage, you may find yourself imposing behavioral controls that transform your relationship with a contractor, giving them grounds to consider themselves employees. Likewise, if the thought of sharing someone with your competition gives you pause, you might be better off with the exclusivity of a full employee.

Remember that even though Mary Kay eventually won their case, it took nearly a decade of legal action – a luxury that you probably cannot afford. Keeping the line between full employment and contract work clear can save you the time, hassle, and expense of a protracted legal battle or hefty penalty.

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