Q: What is the best option for an employer hiring contracted employees -- 1099 or W2?

A: The question of the best payment method for workers has been at issue for many years.  So much so that the IRS has devoted substantial resources over time to auditing and then litigating with those companies it feels have not correctly treated their workers.  So a mistake by a company could be very costly.

Over time, the IRS has established a set of criteria that employers can follow to determine if a worker should be classified as an employee or an independent contractor.  First some background.

When a company hires an employee, the company is not only responsible to pay her the agreed wages, it must also pay employer payroll taxes, which include FICA, or social security taxes -- 6.2 percent of wages paid up to an annual limit which changes every year -- $117,000 in 2014, Medicare (1.45 percent of all wages paid), federal unemployment taxes (0.8 percent of wages paid up to $7,000) and a panoply of state and local taxes, which can include unemployment, disability and several other taxes.  In addition, if all taxes are not paid properly, for example because an employer treated a worker as a contractor instead of an employer, the employer can be liable for penalty tax rates.  All in, the employer payroll taxes could add 10-15% to the cost of basic wages.  Add to that the cost of health insurance, and an employer could be paying 125 percent or more of the agreed wages for an employee’s total package.

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In contrast, if a company hires an independent contractor, the cost of that independent contractor is simply the agreed compensation.  No additional taxes, fees or penalties are due.  In addition, there is no requirement that companies provide health insurance to their contractors.  As a result, an employer would save up to 25 percent or more by engaging only independent contractors instead of employees.

So why don’t employees treat all workers as contractors? Primarily for two reasons.  First, whereas an employer and employee each pay the FICA tax, a contractor must pay both amounts herself.  In addition, a contractor does not benefit from the unemployment or disability taxes an employer would pay for its employees, not to mention the health insurance issue.  Of course, a contractor can deduct expenses that an employee cannot deduct or even if she could deduct, could only do so after she incurs a certain amount.  On balance, though, most workers who understand the economics involved will insist on being treated as an employee instead of a contractor.  Often, the relative bargaining strength of each party will dictate the worker’s classification.

Secondly, the IRS and many state and local tax authorities will come down very hard on a company that misclassifies its workers.  The penalties often include payment of the required employer-based payroll taxes (the 10 to 15 percent mentioned above), interest, substantial fines and penalties -- and the penalties that could be due under the Affordable Care Act for not covering employees as required by the law. 

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To add some certainty, the IRS has promulgated a set of standards that a company can use to determine the correct classification of its workers.  A company (or a worker) can submit a form to the IRS asking for it to determine the correct classification.  The classification will be based on a few broad categories, including the amount of behavioral control a company will exert over its workers (e.g., who sets the hours to be worked, who provides training, who provides the instructions concerning the work to be performed and who provides tools used), financial control (e.g., who pays the expenses associated with the work performed, is compensation calculated on an hourly basis and who sets the rate of payment) and the relationship between the parties (e.g., does a written contract exist, how does the company represent the worker’s status to outsiders, is the worker entitled to vacation and personal days, does the worker perform the same services for others). 

Many companies treat their workers as independent contractors until they receive their first institutional funding.  That is why worker classification is something that we look at carefully at ff Venture Capital when we do due diligence before making an investment.  The IRS does not distinguish between funded companies and those not yet funded when it decides if the company has misclassified its workers.  Accordingly, to the extent we believe a risk exists in the business, it will impact our funding decision, the valuation or other downside protections we would ask for when structuring the investment.  For that reason, and all those explained above, I urge entrepreneurs to work with their accountants and attorneys to understand the risks and opportunities in structuring worker classifications in their organization.

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