Employee or 1099? Time to Take Another Look!

New IRS regs require you to take another look at your 1099 workers. What you need to know!??

Most employers are not aware that independent workers make up nearly 45% of the US workforce. According to a 2023 report by MBO Partners, 72 million Americans go to work each day classified as independent contractors. 30 million of these folks do their work as 1099s in a full-time, every day capacity.

Fortunately, or unfortunately, depending on your POV,? there are some new rules for how employers are allowed to classify a worker as a 1099 (non W2) worker that may impact your business in 2024. These rules were passed in early January but despite law suits from several states will go into effect now – March 11th, to be exact.??

Why Does the IRS Care About How You Classify a Worker??

The IRS has always been interested in how employer’s classify their workers because it directly impacts their tax revenue. Independent contractors are responsible for paying their own taxes, including self-employment taxes, whereas employers are responsible for paying their share of the payroll tax plus withhold the employee’s share. Misclassifying workers as independent contractors when they should be employees can result in significant revenue loss for the government.

The Washington State Department of Labor and the Employment Security Department also pay attention to worker classification issues because a W2 employee is entitled to certain wage and benefit protections that are not available to workers classified as independent contractors. When it comes time to make a claim for unemployment, a 1099 contractor is not typically eligible, but a W2 worker is.

Yes, both state and federal levels of government have a vested interest in how you classify one of your workers.

A Brief History of Classification Rules

The distinction between independent contractors and W2 employees has historically been a talking point between employers and various regulatory bodies for as long as I can remember. From an IRS POV, its always been just a bit too easy for employers to misclassify a worker as an independent contractor to avoid the hassle and costs associated with payroll based taxes, benefit administration, and other administrative and fiduciary obligations that would normally be attached to a W2 employee. The IRS has a long history of inserting rules and “guidelines” for employers to use when establishing the “right classification. I remember when there were 20 factors the IRS felt employers should consider when making classification decisions. Somehow that got whittled down to 3 factors in 2021. In the 2024 guidelines, the IRS has added some new considerations, even referencing options for more, under a new “totality of circumstance” rationale.

What’s Changed?

In 2021, the IRS established rules that put emphasis on the degree of control the employer exerted over the worker as the primary driver of worker classification. The 2024 adds additional considerations, requiring employers to take a second look at workers who they have formerly considered 1099s. Employers are now required to use what is called a “totality-of-the-circumstances” analysis, in which multiple factors are considered – all weighted equally.

The key factors specified in the 2024 ruling include….

• The degree to which the employer controls how the work is done – Who sets hours of work, when, where and how work is performed. This is not anything new.
• The worker’s opportunity for profit or loss – Which requires the employer to get clear about who benefits when a worker’s managerial skills impact the “profits” (or losses) generated from performing the work. For example, who controls the purchasing of the tools or equipment used to do the job? Does the worker have overhead requirements needed to perform the job that the employer does not control?
• The amount and level of skill and initiative is required to do the work – What skills and initiative is required by the worker to complete the work assigned? The more independent the worker is from the employer’s scrutiny of either the worker’s skills or their personal qualities to perform the job, the more likely they are to be considered an independent contractor.? Interview them like you are hiring an employee and run the risk of misclassification.
• The degree of permanence of the working relationship – How long will the worker be attached to the workplace/company? The longer they work for a client, the closer the IRS scrutiny
• The worker’s investment in equipment or materials required to do the work – What are the tools the worker needs to bring to the table in order to complete the work assigned to them;? what tools belonging to the employer can the use without compromising their independence. This “who owns the tools” factor that has been around for a long time. A contractor using only the tools provided by an employer has never been a good look if the goal is demonstrate independence.
• The extent to which the service rendered is an integral part of the employer’s business – If the work performed is critical to the employer’s principle business, it is generally considered integral to that business and supports the need to make the worker a W2 employee.

How Will these New IRS Rules Impact Local businesses??

In the State of Washington, these rule changes are likely to require action from employers who have long standing relationships with workers formerly classified as “independent contractors”. Up until recently, Washington, like several other states, has been using what is referred to as the ABC test to determine whether a worker should be classified as an independent contractor or an employee. The ABC test evaluates only three criteria:

A) Is the worker free from the control and direction of the hiring entity,

B) Is the the work performed outside the usual course of the hiring entity’s business, and

C) Is the the worker is engaged in an independently established trade, occupation, or business.

We are assuming that certain workers who can meet these ABC requirements might fall short under the new rules. It surely means that for employers who regularly use independent contractors, it’s time to re-look at current documents, agreements and contracts to make sure the terms of engagement are clearly spelled out and in sync with the new regs.

At minimum any agreement with an IC needs to spell out…

• The nature of the work. What results or deliverables are key to the agreement
• What each party will do or provide as part of the agreement – eliminating as much as possible any obligation by the client to provide tools or equipment necessary to do the work.
• Payment Terms. Clear outlines of how and when the contractor will be paid for services rendered. Hourly pay agreements are generally not considered favorable to claims of “independence.”
• The Client/Contractor relationship – clearly specifying their independence of one another.

It also means that employers need to maintain accurate records of payments to independent contractors. This includes invoices, receipts, and any other relevant documentation.

In summary, for Washington employers who rely on the use of independent contractors or freelancers on a regular basis, understanding and adhering to the new “totality of circumstance” classification guidelines is critical to avoid potential penalties and issues with misclassification.?

What Happens If You’re Audited for Misclassification Issues.

Not to be scary, but we know that an unfavorable misclassification audit can be costly. Not only is an employer subject to unpaid back taxes (and some cases penalties), you might also be liable for the payment of back wages due to being out of compliance with minimum wage and/or overtime pay requirements.? ?

What Can You Do???

I recently chatted with the owner of a marketing firm in downtown Seattle who was concerned about the growing number of 1099 contractors who had been added to their firm’s “bench list” over the last 6 months. Their bench included copy writers and digital designers who worked on various client projects from time to time but not at a level consistent enough to warrant making them even a part time W2 employee. She had been paying them as 1099 contractors whenever they got assigned to a project as her way to contain her level of financial commitment to her “just in time” workforce. She considered this type of flexible staffing strategy to be key to her business model. Preparing herself for a potential audit given her growing use of 1099s, her goals was to keep her “bench” concept in tact, but do so by avoiding the risk of IRS insertion.

We discussed her options which included…

Requiring any worker assigned to a project to be paid as a W2 employee, in essence prohibiting the use of 1099 contractors on all client projects. This solution avoided IRS scrutiny altogether, but also required her to absorb the extra work and costs it would take to formally hire each worker assigned to a project -even when the workers actual hours of work turned out to be much less than originally anticipated. She was anticipating a lot of hiring and quitting, and lots of paperwork that would accompany those activities.

We talked about whether or not this was a staffing alternative that made business sense given the extra liabilities she would assume to provide these interim workers with W2 driven benefits – both those that are mandated by the State of Washington and or part of their current benefit offering to all W2 employees. She, like most employers attached to these types of flexible staffing models, resisted the idea of incurring the process costs of hiring someone for an unspecified amount of interim work, recognizing it would more than likely slow down her ability to deliver services to her clients in the timeframes required.

We discussed the option of using an Employer of Record (EoR) Service provider (like PACE) to automatically convert all their current 1099? workers to W2 status, but as employees of a co-employer partner, not their own. By finding an EoR partner she could outsource all the steps of hiring and onboarding to a third party plus ensure that the IRS would never come calling about any misclassification, as all workers would be made the W2 employees of a third party staffing partner.

I reminded her that EoR services differed from more traditional payroll service options in that in an EoR service relationship your “partner” doesn’t just calculate and deliver a paycheck to your worker, but does everything necessary to be formerly recognized by the IRS and state regulatory agencies as their “employer of record” – thereby eliminating any hidden costs related to the employer liability.

In the end, she elected to use our EoR service model, customizing its execution so that each hour of work performed by one of her former 1099 workers would not only be attached to our W2 employee’s payroll record, but would be used to track work performed to a unique project code. We made some simple changes to our current automated time tracking system that required each employee to submit their hours of work not just by date they were performed by but work type and project code, allowing? PACE to provide weekly reports of pay and potential client billing back up.? Our ability to customize this payroll process to add value to our client’s pricing and billing model was clearly a plus!

PACE has been offering Employer of Record services to our client base for more than a decade, starting during that time after 2008 when worker classification issues first started to get serious IRS attention.? ?One of our clients has been using our EoR service model on an ongoing basis for over 6 years, asking us to hire, onboard and assignment over 200 professional workers each year.? These employees would get assigned to a variety of service projects on an interim, hourly basis throughout the year. Again we can deliver our client reports of the payroll costs attached to each project, each type of work performed by their 200 workers who are now our employees.

We believe our EoR service option has delivered significant value to this employer or any employer who has an ongoing need for interim workers who they can easily source on their own but need to get to work quickly and efficiently while operating in an IRS? compliant way.

Using EoR Services to Manage an Out of State Employment Arrangement

Another set of clients have used our EoR services to maintain a W2 working relationship with valued employees who would have otherwise been forced to terminate their employment given their family’s decision to move out of State. These employees were open to continuing to work remotely, so, rather than our client going thru the costs and hassle of establishing a nexus with another State’s? workers comp and employer services regulatory bodies, they elected to use our EoR service model so that we became their employee’s W2 based employer of record.? In each case we already had established a payroll based nexus with that State allowing our clients to smoothly and seamlessly retain a valued employee despite their physical relocation.? ? ??

How PACE Can Help?

At PACE, we understand the challenges of managing worker flexibility while also staying compliant with regulations that are frequently changed or adjusted at either the State or Federal level.? Our Employer of Record (EOR) services offer a solution for businesses seeking to engage workers in flexible work arrangements while mitigating the risk of IRS insertion.? By serving as the official W-2 employer for tax and legal purposes, handling all payroll, benefits administration, and compliance requirements, our clients can stay focused on their core business activities, not having to worry that they will trigger an IRS sniff check!

Transitioning a long term 1099 worker into a W2 employee role also is a win for the independent contractor, providing them with greater financial stability (they get paid weekly) legal protections, and access to benefits they otherwise would not be able to tap into in their 1099 format.? Ultimately, we have used the EoR service model to support a more positive and risk free employment relationship for both our client and their worker.

In a typical E of R service process PACE….

• Streamlines the onboarding process including all compliance requirements?
• Collects timecards and pays all workers weekly
• Administers all mandated and voluntary benefit offerings
• Manages rate of pay agreements
• Submits pay and tax reports to regulatory agencies?
• Processes annual W2 preparation and follow up??
• Oversites all state regulatory requirements including responding to claims of unemployment benefits

Mark ups over bill rates for EoR services are nominal and typically decrease as the volume of employees covered under an EoR service agreement increases.

PACE Staffing Network is one of the Puget Sound’s premier staffing /recruiting agencies and has been helping Northwest employers find and hire high impact employees based on the “right fit” for over 45 years.

A 5-time winner of the coveted “Best in Staffing” designation , PACE is ranked in the top 2% of staffing agencies nationwide based on annual surveys of customer satisfaction.

PACE services include?temporary and contract staffing,?temp to?hire?auditions,?direct hire professional recruiting services,?Employer of Record (payroll) services, and a large menu of?candidate assessment services?our clients can purchase a la carte.

If you’re a hiring manager looking for a service that will actually “make a difference” to who and how you hire, contact us at 425-637-3312 and we’ll be in touch!