If you think your business is too small for the government to care about, think again. Government agencies, like the IRS, the Department of Labor, and state agencies, have definitive standards on what constitutes an employee or a contractor, and mistakes can be costly. 

Here are five costs you may not expect that come with classifying someone as a 1099, when they should have been a W-2.

1. Back taxes: at minimum, the IRS will calculate the taxes you should have been paying on your employee, including income (withholding) tax and Social Security, for up to three years back.
2. Benefits: if the government believes you have failed to provide benefits such as overtime pay, unemployment insurance coverage, and health care, they will calculate what that adds up to and require you to reimburse the worker.
3. Interest: Not only will you have to pay back taxes from the past months or years, you’ll likely be charged interest on them too.
4. Fines: Everyone makes a mistake sometimes, and the government understands that. If they determine you unintentionally misclassified someone as a 1099, they may ask you to pay the back taxes and go on your way. However, if they believe that you willfully chose to classify someone as a 1099 when they should have been a W-2, you’ll likely receive a hefty fine in addition to the taxes you owe.  In addition, there may be fines for related compliance issues, such as failing to process an I-9 for your misclassified worker.
5. Jail time: This one is extreme, but if the government determines that you have willfully misclassified worker(s), you could not only end up with a huge fine, you could land in jail.

Unfortunately, there’s a lot of misinformation on the internet, and there’s often the assumption that as a business owner, you have a choice of what works best for you. There are definitely legitimate reasons to have contractors on your team, but if the government feels that you’re calling people contractors when they should be employees, the costs can add up very quickly. 

Does this mean that you need to immediately need to switch all your contractors to employees? No. But we would suggest that you take the time for a little due diligence to check your compliance. 

If you find yourself in a grey area, one approach is to err on the side of caution and classify your team members as W-2 employees to mitigate your risks. It can be a challenge to make that change, but if you need help, Dunathan Consulting is only a phone call away. 

*Note: Dunathan Consulting does not provide legal advice. This article is strictly informational in nature and should not be construed as legal advice. If you need a legal opinion on an employment issue, consult a qualified lawyer. 

Growing your team is an exciting (and scary) thing for small business owners, especially when it comes to classifying team members as employees or contractors. 

What’s the difference between an employee and a contractor? 

Employees (often referenced as “W-2” because of the IRS W-2 form sent to the employee at year-end) are people dedicated to your company. Whether they’re full-time with a salary and benefits, or part-time hourly remote workers, employees are focused on your company as their main job, and you control the work they do. 

Contractors (or “1099s” because of the IRS 1099 form sent to them at year-end), on the other hand, are experts in their field who are running their own businesses. Unlike employees, contractors control their own work and figure out how to accomplish your desired outcome.

As an example, if you need a new website, you could hire an experienced contractor to complete the project. You are unlikely to tell them to use a particular design software or how to go about coding a page, rather you’d provide specific requirements and they’d figure out how to deliver them. 

Unfortunately, not every role is as clear-cut. The first member of the team is often a part-time assistant to the business owner whose hours vary, and it’s tempting to try to hire them as a contractor because the paperwork is less complex. 

Employee or Contractor? 

The truth is that it’s not really your choice; it’s a factual classification based both on the job requirements and the individual you choose to fulfill them. The IRS has rules on what makes a contractor, but even the IRS says “There is no “magic” or set number of factors that “makes” the worker an employee or an independent contractor…” so how are you supposed to know?  Let’s take a closer look, using our example of an assistant. 

Chances are, you’re providing a list of tasks to your assistant and giving them clear direction on how you want things accomplished. Because you are controlling their work, the IRS would likely classify them as an employee. 

An exception would be if you contract with a company that provides virtual assistants. Even though you still have an assistant for whom you are controlling the work, you are paying the larger company, not the individual. Essentially you are hiring a staffing firm, not an individual.

Which one is “better”?

When business owners worry about what’s better, they are often thinking in terms of cost. Is it better to pay a higher hourly rate to contractor, or bring in an employee that may have a lower hourly rate, but will require you to pay taxes?  Let’s use social media as an example to explore this. 

If you bring on a social media contractor, you’ll be gaining a team member with expertise on social media. They’ll likely be familiar with different platforms and strategies to get your audience engaged, but they won’t be familiar with your company. A contractor is an outsider, who might be able to create great content, but they will only know what you take the time to tell them.

Alternatively, if you brought on an employee to do social media, chances are they would not have the same level of social media expertise as a contractor. But they would know your company from the inside out. In this case you might give up a sophisticated growth strategy, but have authentic content. 

What’s better? That’s a choice about what’s most important to you – expertise vs. inside company knowledge.

The person matters

Let’s go back to our example of an assistant and say you had initially hired them through a virtual assistant company. At some point they decide to leave the company, but you decide to keep working together. You’ll now be paying them directly, so would they be a contractor or an employee? 

While you may still consider the role as something that can be outsourced to a contractor, if the person is now working for you, and no one else, then you might want to hire them as an employee to minimize your risk. It doesn’t matter if you only pay them 10 hours a week, and if they have the intention of gaining other clients.  

It also doesn’t matter if they want to be a contractor rather than an employee – it’s not their choice any more than it’s yours. If you are their only source of income, the IRS is not likely to believe that the individual is truly an independent business (contractor) because they’re not operating as a business.

That’s a lot to think about and you can see how things can get confusing. Fortunately, there’s a fairly easy way to do some research: the internet.

Search for the person you’re planning to bring on board. Did you find a website for them that shows they are actively marketing their services, or just a resume? Have they registered their business with their state agency? (Note that some states don’t require sole proprietors to register, so this test is not definitive.) If they are registered to do business, and are actively marketing their company and services, and are serving multiple clients, it’s less risky to treat them as a contractor.  If you can’t find any evidence of their business activity, you might want to consider them an employee.

What if I get it wrong?

Treating someone who should be an employee as a contractor can come with penalties if the government discovers your mistake, and it can be costly.  Read more about the risks here, or contact us today to learn the best way to grow your team.

Does your business run smoothly when you’re not there?  Do your staff know how to manage the day-to-day things, like processing bills for payment, finding the company policy on holiday pay, or setting up an email address for a new employee? Well-run administrative functions, like finance or HR, not only free up your time, but also can have a big impact on your business’s profitability.

I’ve been doing OK so far, can’t I just deal with issues as they come up?

Operations are the internal engine of a business. Just as a vehicle will only run smoothly if its engine is properly maintained, a business will only run smoothly if its operations are properly maintained.  If you only change the oil when your engine light comes on, the engine is going to break down more quickly – and maybe it’ll fail unexpectedly just when you need it the most.

What does a well-maintained operation look like?

• You have processes in place for things like paying bills, onboarding new employees, and setting up access to key applications – so no one has to re-invent the wheel every time
• You know where the business’s money comes from and where it’s going, so you can make better decisions
• You and your staff understand how things work at your company, which reduces confusion and increases efficiency and job satisfaction
• You feel confident about growing because you know that behind the scenes, everything is orderly, not chaotic

So what does your small business really need?

Financial Management –In order to effectively operate a business, you have to know where the business’s income is coming from, what it’s being spent on, and whether or not the business is turning a profit. Many business owners start out by tracking all of this in their heads, but there comes a point when it’s too much to truly keep track of.  Once you have a good financial system and processes in place, you’d be amazed what the data tells you about what’s really going on in your business.

Human Resources –In any small business, a small number of employees are responsible for many tasks, so it’s especially important to employ the right people. Hiring the right people, onboarding them effectively, setting clear expectations, paying them timely and accurately, and having a good performance review process are all crucial to finding and keeping good staff.

IT – We all know how frustrating it is to have a problem with computer equipment or software and not be able to get help when you need it.  For a small business, if one employee can’t get their work done due to a computer glitch or software training issue, the effect could be huge.  Picking the right hardware and software, providing good training, and having someone to call on for help are all key to smooth operations.

Marketing – Every business needs to let potential customers know that it exists, or it won’t have anyone to sell to.  Basic marketing practices, like identifying your target markets and marketing to them, are much easier when you have processes in place to capture contact information in a marketing database (or CRM), keep the information clean, and use it to execute your marketing strategies.  Have you ever had a great idea for marketing, but got stuck when it came to the logistics of making it happen?  Or hired a marketing agency, but couldn’t provide them with a list of people to market to?  Having good marketing data management in place is the basis for good marketing.

With good processes in place to keep your operations running smoothly, you’ll be able to focus confidently on planning for your business’s growth and success.  If streamlining your small business operations is your goal, Dunathan Consulting is here to help. Contact us today and we will be happy to provide a free consultation!