Employers must pay attention to these forms before sending them to their employees and independent contractors.
When businesses need additional resources to complete a task or a project, the business owners instruct their talent acquisition teams or associates to look for freelance resources. If the project cannot be outsourced, the business owners choose to employ a dedicated resource for the project or set of tasks. This is the fundamental functionality of how businesses approach hiring an extra set of hands for their operations.
The amount of work, set of responsibilities, and other particulars remain the same for both types of resources. The only difference is that the employer will only offer certain employee benefits to the employee resource, such as salaries+ variables, health insurance, annual bonus, unemployment, and more. An independent contractor is only paid for the services that they provide as agreed.
Even though the calamities of both business arrangements seem pretty clear, the blur looms in as soon as the work arrangement goes remote.
For example, if a business hires you as a freelance designer for their products and you’re expected to deliver the required work on a daily basis (just like a regular employee), the business is still going to send you a Form 1099-NEC instead of a Form W-2.
The following table will help you understand a few key differences between the two types of resources, giving you the full picture of differentiation.
Understanding The Differences Between Employees And Independent Contractors
| Employee | Independent Contractor |
| The employee is compensated with wages, salaries, variables, bonuses, health insurance, unemployment benefits, and more. | Independent contractors are compensated with non-employee compensations |
| The employee is hired by the employer | Independent contractors are self-employed |
| The employee compensations are reported on Form W-2 | Independent contractor compensations are reported on Form 1099-NEC |
| An employee works under the control and direction of the employer | Independent contractors cannot be controlled or directed by the employer |
| The employee works for the employer | Independent contractors work for multiple organizations |
But when you look at the similarities between the two profiles, you can understand why businesses often misclassify their employees as contractors and vice versa.
The distinctions above are textbook differentiations to help you classify your resources.
A tax perspective, or rather a tax regime, which functions to differentiate each of these resources will help you define who is an employee and who is a contractor.
Tax Regime For Employees
Employers send copies of Form W-2 to employees to classify their resources as paid employee resources.
Employment benefits, such as salaries, wages, incentives, bonuses, allowances, variables, health insurance, paid casual leave, paid sick leave, unemployment benefits, and so on are reported on the form along with the employee’s TIN or social security number.
Any employee pay-related tax withholdings must also be reported on W-2.
Businesses define employees as dedicated resources that only work for their organization and their assignments while defining contractors as freelancers that take up gig work from a variety of organizations.
Tax Regime For Independent Contractors
Employers or entities that hire independent contractors or freelancers compensate the resources with a mutually agreed payment in exchange for the services.
The employer and the contractor can define their terms and conditions prior to the commencement of work, enabling both parties to work in compliance.
The most crucial factor in the business-contractor arrangement is that the businesses verify the contractor’s profile prior to onboarding them. This is done to check and validate the credibility of the contractor.
Businesses report all non-employee compensations on Form 1099-NEC along with the vendor TINs. Payments made to independent contractors in exchange for their services are reported on Form 1099-NEC.
A copy of Form 1099-NEC is sent to independent contractors for informational purposes.
When an employer chooses to send either a Form W-2 or Form 1099-NEC, the business or the organization is classifying the resource either as an employee or an independent contractor. This classification is the defining factor for a lot of businesses.
The Cost Of Misclassifying Your Resources
If you have mistakenly misclassified your employee as an independent contractor or misclassified your contractor as an employee, then you are not the only one. Many businesses in the past have made the taxing mistake of misclassifying their employees as independent contractors.
Some employers misclassify employees for tax benefits, while others do it for the no-strings-attached business arrangement that freelancers offer.
While the approach is quite tempting, here are the consequences.
- Employers can be sued by the misclassified employees for the misclassification
- Employers may have to pay damages or settle the case with hefty compensations
- The jury is free to restrict/limit/prohibit the operations of the business/employer depending on the severity of the case
- Misclassification lawsuits mean reputational and financial losses for your business
- Misclassification could affect your company’s goodwill, stripping your company of its years of hard work overnight
This is not something we’re saying to scare you. Businesses like Uber, Lyft, Lime, and more had to pay hefty penalties and settlements for misclassifying their employees as independent contractors.
“But why the lawsuits?” you may ask.
Here’s the thing.
When employees are misclassified and represented as independent contractors to the IRS, the employee misses out on certain employment benefits, such as health insurance, unemployment, paid leaves, and more.
Independent contractors are self-employed and this means that the person/entity that’s hiring them is not responsible for providing any of these benefits to them.
And the contractors don’t expect the employers to cover for these things.
But employees do.
How Do You Classify Your Employees and Contractors Correctly?
You can start with defining your employees and independent contractors for what they do and their relationship with your company. Of course, these factors change as the business and the ecosystem change. However, the standard principles of employment are applicable to check if a resource is an employee or a contractor.
This guide will come in handy to test a few practical approaches to conclude the type of resource you’re in an agreement with.
After you have defined the resource and their relationship with your organization, the next step is to send the right IRS forms to the employee or the contractor.
An employee must receive a W-2 form and an independent contractor must receive a 1099-NEC form from the employer/entity.
Employers will be penalized for not sending W-2 forms to their employees.
The W-2 form must report all employee compensations and tax withholdings, while Form 1099-NEC must only report the payments made to contractors and the tax withholdings.
The W-2 form must report the respective taxpayer identification number (TIN) or social security number (SSN) of the employee and the 1099-NEC form must also be used to report the TIN, SSN, or Employer Identification Number (EIN) of the contractor.
Role Of W-9 For Validating Vendor TINs
To obtain the TINs from the vendors, businesses must send out Form W-9 to ensure that the vendors provide valid and accurate TINs. This step must be conducted at the very start of the association to prevent TIN discrepancies.
Remember that each TIN discrepancy with the IRS can cost you at least $250 in penalty + interest and the interest will continue to accrue until your business addresses the issues cited by the IRS.
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This further eases the stress on your accounting and compliance teams, ensuring accuracy and reducing the burden during timeline-sensitive scenarios.
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There is no easy way out for businesses, especially when you are depending on someone’s hard work and effort to get things moving for you. Stick to the rules and you will get by. Any CPA or financial advisor will give you just one plain piece of advice in these scenarios, which is to stay away from misclassification, no matter what.
Useful Reads:
Form 1099-NEC Changes For 2021 Tax Year
Form 1099-MISC Changes For 2021 Tax Year
1099 NEC or MISC: Which One Should A Business File And When?
Employee Misclassification: How It’s Costing Gig Economy Companies Millions Of Dollars In Penalties
