With contract employment on the rise, an increasing number of businesses are hiring specialized workers on a contingent basis in order to help with completion of a project, or to fill in for an absent employee. These contract assignments can last anywhere from weeks to years at a time. By hiring these contract workers, companies enjoy the benefits of hiring a team of qualified professionals on an as-needed basis, maintaing a flexible workforce and, in many cases, helping their bottom line.



While bringing in contract employees can provide businesses with some much-needed relief during projects or busy seasons, it can also raise confusion when it comes to classifying them for tax purposes. IRS fines and penalties for incorrectly classifying employees are steep, but can be avoided by knowing the differences between employee classifications.

What defines a 1099 or W2 worker?

The easiest way to avoid employee classification errors is for employers to maintain a clear understanding of the factors that determine an employee's status as 1099 or W2, and the differences between the two. An easy way to determine the appropriate status of a worker is identifying his or her terms of employment. A 1099 employee has a contract with a very specific end date. The worker is free to set their own schedule, and is only responsible for completing the project by the date specified in their contract. On the other hand, a W2 employee has a set schedule of work hours managed by the employer and has no specified end-date of employment. Essentially, a 1099 employee is paid on a project basis, whereas a W2 employee is paid based on hours worked.

The penalties of misclassifying workers

If an employee is incorrectly classified, the ramifications can be severe. The fine for an intentional misclassification can be a penalty equal to 100% of the amount in taxes owed. In cases where an employer negligently reports or under-reports employee status, the IRS can impose a 20% accuracy-related penalty.

Correcting classification errors

If an employer realizes he or she has been misclassifying employees, there is no need to panic, but corrections should be made as soon as possible. While there is no way to change the past, the best thing to do is make the changes going forward. Companies should also be aware of the potential for audits and prepare accordingly. In recent years the IRS has been very aggressive about payroll taxes. Audits can be prompted by disgruntled former contract employees who feel they have been misclassified and decide to file a complaint.

The confusion of classifying workers in accordance with IRS standards can also be avoided by hiring an outside company to act as the legal W2 employer of contract workers. This process can often provide significant benefits to companies, because of the many questions and confusion surrounding classification. One of a company's worst fears can be tax risks, and outsourcing payroll for contract workers can help mitigate those risks and ensure tax compliance.