Each year tax professionals interview workers who believe they are self-employed but who are – according to the tax code – actually employees. So, what are the differences between an Employee who receives form W2 and an Independent Contractor who receives form 1099-NEC? In a nutshell, and greatly generalized:
If the employer has the legal right to control how and when an individual performs the duties of their job, that individual is an employee and will receive form W2.
If the only control the employer has over an individual’s work is the result of the finished product/services, the individual performing the work is an Independent Contractor and will receive form 1099-NEC.
The IRS published a 20 Rule Test for Establishing Employment Relationship.
Individuals who believe they are being paid incorrectly as either an Employee or as an Independent Contractor may want to review the 20 Rule Test, apply it to their own situation, and discuss it with their employer. Keep in mind, the 20 Rule Test is only a guideline; there may be other ‘facts and circumstances’ or specific legislation which effect the final determination between Employee or Independent Contractor.
There are both benefits and disadvantages to being classified as an Employee or as an Independent Contractor.
- Employees are only responsible to pay 50% of their FICA taxes (Social Security and Medicare taxes.) The Employer is responsible to pay the other 50%. Independent Contractor’s pay the full amount of FICA taxes themselves through quarterly, estimated tax payments.
- Employees are generally covered by a state unemployment and/or disability program and worker’s compensation, in the event they become unemployed or disabled; their employer pays the ‘insurance premium’ on their behalf. Independent Contractor’s must make arrangements for these types of benefits and must pay the ‘insurance premium’ themselves.
- Employees are often offered an Employee Benefit package. This package may include policies for health benefits, vision and dental care, and/or life insurance. Other benefits offered are reimbursement of transportation costs, parking fees, and business travel expenses. Many employers offer a retirement plan, and often the employer will contribute additional funds to that plan at no cost to the Employee. Some employers offer perks like snacks and coffee in the break room, weekly/or/monthly office parties, or entertainment – theater tickets, athletic events, etc.; I’ve even visited a business location where nearly half the ground floor of the business was a full service gym – complete with personal trainers – which was open and available to all Employees of the company at no charge to the Employee – this was a huge benefit to the Employee, and the people who worked for that business were very happy, indeed. These Employee “perks” can save the Employee a great deal of their hard-earned money each week/month/year.
Independent Contractors have none of the Employee perks, other than those they pay for themselves. While it’s true the cost associated with the perks Independent Contractors buy for themselves may be a deduction against the fees they collect for their product/services, not all of those costs are deductible.
- Meals must have a business purpose, be ordinary and necessary to the business, not be lavish or extravagant, and only 50% of the cost of a meal is deductible from the gross self-employment revenue
- Entertainment is only deductible in limited circumstances
- Travel costs may or may not be deductible, dependent upon the reason for the travel and the needs of the business
- Gym fees are rarely deductible for the Independent Contractor, and I dare say never deductible
- FICA taxes are never deductible in determining net profit, nor is health insurance or retirement plan contributions. These three items are, however, an adjustment on the Independent Contractor’s personal income tax return and will reduce their taxable income. These three items will NOT reduce the amount of FICA taxes owed on the self-employment net profit.
On the flip side, Employees are at the complete will and control of their employer – their shift hours, their work attire, how they do their job, perhaps even business protocols on what they say and how they are to say it. Independent Contractors are at the complete will and control of themselves. So long as they maintain professional standards, they control when they work, what they wear at work, how they do their job, including hiring Employees or Independent Contractors to do a portion of the job they don’t wish to take on themselves. This “control” over their business is often lucrative enough to be more appealing than all the Employee perks listed above.
What about California? California has a very different take on the Employee vs. Independent Contractor controversy. In 2019 California enacted Assembly Bill (AB) 5 addressing the issue. AB-5 enacts the “ABC Test” to determine who is or is not an Employee; this test makes it very difficult to be classified as an Independent Contractor in the State of California. The A, B and C of this test are:
A. The worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact;
B. The worker performs work that is outside the usual course of the hiring entity’s business; and
C. The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.
There are some specific situations where the ABC test is not applicable; AB5 lists certain individuals exempt from the ABC test. These workers are subject to the Borello Test – a federal test which applies Behavioral Control, Financial Control and Relationship of the Parties.
California legislation has also created a list of Statutory Employees – workers who are classified as Employees no matter the situation as defined by legislative authority; these workers may include:
- Corporate Officers
- Agent/Commission Drivers/ Traveling/City Salespersons, and Home Workers
- Artists and Authors
- Members of an LLC Treated as a Corporation for Federal Income Tax Purposes
- Certain Employees in the Construction Industry
IT IS POSSIBLE for a worker to be classified as an Employee for state income tax purposes and as an Independent Contractor for federal income tax purposes – especially in the State of California. Tax professionals should become familiar with any specific regulations in their home state.
Workers may have difficulty understanding the unique and often complex terminology of tax law, so I would advise anyone who is considering going into business for themselves to contact their tax preparer before becoming an independent contractor so you’ll have a better understanding of what your tax situation will be in the future.