Any business owner knows that overhead expenses are by far the most substantial expenses on their balance sheet. It doesn’t matter if you sell widgets or provide a service – an inability to estimate your overhead correctly can be the difference between success and failure. One of the biggest overhead expenses of any business is labor – the wages, the cost of benefits, payroll taxes.
In this blog post, we will explore the fundamental differences between the two employee classifications: 1099 and W2 employees. We will also consider how the classification affects those labor costs to your business, the pros and cons of each classification, and when each should be used.
Classifying employees correctly can be confusing. As the recent Uber and Dynamex court cases show, any business that has 1099 employees, particularly one that is located in California may be on the unsteady ground as far as employee classification goes. The new “ABC test” (more about it below) that came out of the above-mentioned court rulings is currently applicable only in California although it is likely that other states will follow suit. It may be a good idea to consider reviewing your employee classifications to make sure you can prove the reasoning behind them.
We’ll also talk about the workers compensation insurance. What does it cover? When do you need to purchase it? How do the different employee classifications affect your policy? The Microsoft and Time Warner court cases are another example of how an incorrect employee classification can cause a financial fallout to the tune of millions of dollars.
Let’s start with looking deeper into both employee classifications – 1099 (aka independent contractors) and W2 employees.
What is an Independent Contractor (1099)?
According to the IRS, “independent contractor” includes people such as doctors, dentists, veterinarians, lawyers, accountants, contractors, subcontractors, public stenographers, or auctioneers who are in an independent trade, business, or profession in which they offer their services to the general public. However, whether these people are independent contractors or employees depends on the facts in each case.
The general rule is that an individual is an independent contractor “if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done.”
- As an independent contractor, a 1099 employee is not considered a true employee of the company; thus they do not fall under the protection of labor regulations such as Americans with Disabilities Act (ADA), OSHA (Occupational Safety and Health Act), unemployment compensation or workers compensation insurance
- The independent contractor is responsible for paying their own taxes, i.e., the business does not deduct social security, Medicare or any other standard deductions from the paycheck
- The independent contractor is not eligible for overtime pay, benefits and is not subject to Fair Labor Standards Act (FLSA) regulations regarding record keeping or youth employment.
The pros to 1099 employees include savings on labor costs such as insurance, healthcare, overtime. You can also hire a contractor with a specific skill set you need, as well as use them (and pay) on demand as your business requires.
The biggest con of this classification is the amount of scrutiny you may undergo with IRS if they decide to review your classifications. You will also encounter higher hourly rates and inability to plan for extra work. If an emergency arises, the contractor might not have the capacity to put in the extra hours you need.
What is a W2 employee?
Lets look at the IRS definition of a W2 Employee:
“Under common-law rules, anyone who performs services for you is your employee if you can control what will be done and how it will be done. This is so even when you give the employee freedom of action. What matters is that you have the right to control the details of how the services are performed.”
As a W2 employee, the individual falls under the regulation and protection of various FLSA laws such as ADA, OSHA, workers compensation, etc. Where a 1099 employee is not eligible for anything, a W2 employee may be required to receive benefits, overtime, and healthcare. The employers also have to comply with minimum wage requirements.
The pros of a W2 employee include building a company culture and promoting teamwork (which is harder to do with a remote, independent contractor), the ease of recruiting since a lot of folks are interested in a permanent position with benefits, as well as the ability to shift work between team member if an emergency arises.
The cons include paying more in taxes and general labor costs. Also, a W2 employee is harder to fire. Unlike with contractor where you just terminate the arrangement, firing an employee involves a whole process to protect yourself from a possible lawsuit.
We can’t talk about the correct process to fire employees that are not working out, without mentioning an essential tool in your arsenal that can protect you in case of a wrongful termination lawsuit – an Employment Practices Liability insurance policy (EPL).
This policy is designed to protect you, the employer against claims alleging wrongful employment practices such as wrongful termination, sexual harassment, and discrimination (please read your policy or insurance proposal to confirm exact coverages).
Classifying your employees
The biggest challenge of correctly classifying the employees is determining the degree of control you have over the worker. No wonder the task of classifying the workers is so confusing – the definition is vague and open to interpretation. Not only that, but the recent court case Dynamex Operations W., Inc. v. Superior, has set a precedent placing the burden of proof on the employer to determine if someone is an employee or a 1099. Basically, if you can’t prove without a doubt that the worker is truly an independent contractor, it may be safer to classify them as an employee.
Under California’s new “ABC test” the business needs to prove that all 3 conditions are met to classify a worker as a 1099 employee:
(A) The worker is free from control and direction of the hiring entity in connection with the performance of the work, both under the contract for performance of the work and in fact;
(B) The worker performs work that is outside the course of the hiring entity’s business; and
(C) The worker is customarily engaged in an independently established trade, occupation, or business.
Earlier this year, Uber’s drivers were determined to be independent contractors by a U.S. Philadelphia judge in a case Razak v. Uber Technologies Inc.
If we look at the ABC test requirements we can see that an Uber driver satisfies all three of them:
- the driver works when they want, can run errands in between rides and have sole control over the rides he/she commits to (requirement A)
- the driver performs a completely different function than the hiring company – uber is a software company not a taxi company (requirement B)
- and they do engage in an independent occupation (requirement C).
It’s also important to note that a method of payment has nothing to do with classifying the employee correctly. You can pay someone commissions, but they will still be classified as your employee and not an independent contractor. Meet Anne, a salesperson for XYZ Car Dealership.
Even though Anne is paid on commission from the sales she makes, she is still most likely an employee. She needs to show up at work during agreed upon times (and not when she feels like it, as an Uber driver would); she sells the cars while the dealership is open to the public and not when she wants, out of her own business place.
When do you need a workers compensation policy?
Now that we have determined how to classify 1099 vs. W2 employees correctly let’s take a look at how the classifications affect Workers Compensation Insurance.
Workers Compensation insurance is a mandatory insurance policy that covers the employees of your company for any work-related injury or death. The policy will cover the cost of rehabilitation, disability payments and medical and hospital bills to treat the employee’s injury or illness.
Unless your employees are independent contractors, they must be covered by the workers comp policy. This is another instance, where the importance of correctly classifying your workers comes into play. It’s not enough to just declare someone an independent contractor. They need to actually be an independent contractor, according to the new ABC test outlined above.
Back in 2000, Microsoft had lost an 8-year long case involving temporary workers that they classified as independent contractors. The workers argued that they were entitled to benefits under Microsoft’s benefit plans as well as workers compensation insurance. Microsoft was obligated to pay out $96.9 million to the misclassified workers.
How does the California Supreme Court ruling impact workers compensation insurance?
One of the biggest grey areas in commercial insurance that surrounds workers compensation:
- Are Independent Contractors covered if they’re injured while performing work?
- Are the costs/payrolls paid to Independent Contractors picked up on the company’s workers compensation audit at the end of the policy period?
The Uber and Dynamex court decisions put pressure on all the “gig economy” companies. While they still can get around the ABC test by passing requirement B where the independent contractor is performing a completely different function than the employer’s primary business, there will be much more scrutiny.
Workers compensation carriers determine their rates based on the company’s industry and the number of eligible employees. The carriers are now starting to require the independent contractors to carry their own workers compensation insurance or be covered under the employer’s policy. Reason being is that the carrier may be on the hook to pay if the employee was misclassified. What are they going to do to offset that risk? Shift the cost to the employer, of course.
1099 vs. W2 Employee: Which Is Better for Your Business?
So how do you determine which to hire? There are three main questions that you should ask yourself:
- How many hours do you need this person to work? The amount of hours, the consistency of work hours and how long-term the position is, all play a role in determining which classification is the best fit.
- What is your budget? A 1099 employee will likely charge a higher hourly rate, but a salaried worker will cost you more long-term in benefits and payroll taxes.
- Can this person work from home, for example, a freelancer from a freelance website like Upwork? Do they need to be in the office interacting with a team?
As you can see, classifying your employees correctly is incredibly important. While there is enough information about the subject to make one’s head spin, we encourage every business that has 1099 employees to review their employee classifications and make the appropriate changes to their workers compensation policies.
To learn more about Workers Compensation or EPL Insurance, you can always reach out to a member of our team by phone 646.854.1058 or email firstname.lastname@example.org at any time. Or create an account here in order to get a quote!