How to Tell the Difference Between a W2 Employee and an Independent Contractor
In the wake of the rise of the “Gig Economy” in the past decade more and more states are taking aggressive action in dictating who is, or is not, supposed to be considered for self-employed status. In some states, this is as lax as only requiring 1099 to be able to be paid as an independent contractor, but in the state of Washington, there exists a great example of the rules and regulations that are coming down from state government offices to businesses seeking to limit their W2 eligible workforce.
Washington state has very clear and specific guidelines on who can actually be considered “independent” according to the authorities over at Employment Security (unemployment) and Labor & Industries (workers’ compensation) that dictate whether you can call yourself (or a new hire) a contractor, laid out in 6 parts:
- You must be free from control or direction by the business contract with you; this means they can contract with you to do a job but not tell you how to do it.
- Your service must satisfy the following three parameters:
- Your service is outside the normal course of business for your customer; meaning it cannot be the same service they pay a W2 employee for (i.e. accounting firms cannot contract bookkeepers to do work as 1099 vendors if they employ bookkeepers as W2 employees as well).
- Your services are performed outside of all your customers’ places of business; you can’t work in their office/workspace.
- You are responsible for the costs of the principal place of your business; you pay the rent where you work and all the itinerant costs.
- You must also fulfill one of the two following conditions:
- You must be “customarily engaged” in an independently established business; pretty much means you need to be providing the service you started your business to do. If you’re a real estate brokerage but someone tries to engage your services as a marketing consultant, they may be crossing the line here.
- You must have a place of business that is eligible for a business deduction on an IRS return; home office deductions qualify here as do any other space rentals for business.
- You are responsible for filing a schedule of expenses with the IRS; this can take the form of a Schedule C attached to your individual return (1040) or the naturally included schedules attached to the 1120S return prepared by Formations.
- You have established a business license with the WA Department of Licensing and/or a filing account with the WA Department of Revenue for state excise and sales/use tax.
- You are maintaining a separate set of books or records that reflect all items of income and expense; if you are a Formations customer then this is already happening!
Does that seem to you like a lot of information? You are not alone: one of the most audited issues with most businesses in WA and other states is the payroll information submitted to them. Many small businesses had run afoul of the state employment agencies merely by misunderstanding how to treat independent contractors and salaried employees.
The important thing to remember as a shortcut is independence; the more control exerted on the work of the individual the more likely that individual should be a W2 employee. Does your customer control when/how/where you work? Do they ask you to do work that you do not normally offer in your business? Then you may be crossing into W2 territory.
These are important questions to ask yourself as a business owner as well: if you’re looking for help with your business operations and are unsure how to treat the people you’re looking to contract with then ask some simple questions first:
- Does this person have a business license?
- Do they file a business return or schedule with the IRS?
- Can they perform the work independently of your direction and supervision?
- Do they perform this work for other customers?
If you can answer yes to all of them you are likely in the clear, if not then you may want to ask a professional (like your Formations representative) to assess the situation. It is a great idea to get some documentation from the vendor as well:
- W9 form
- Invoices detailing service provided and cost
- Copy of business license with the state (if in WA then this can be searched for on the Secretary of State website with the company name and/or Unified Business Identification number)
The penalties for improperly tax treatment of your vendors can be very costly and can include:
- Back taxes owed for unpaid ESD and L&I (and now Paid Family Medical Leave) can be levied with penalties and interest compounded by the lateness of the tax filings and payments.
- Additional employment taxes due to the IRS because of the reclassification of vendors into employees, again with penalties and interest compounded by the lateness of the tax filings and payments.
- Accounting and tax preparation fees for representation during the audit and correction of tax filings/payments afterward.
These can add up fast and quickly make it impossible to sustain your business.
If you have any doubts about how to pay a vendor or get paid by a customer contact us at Formations today! We are here to help!
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