New IRS regulations require you to take another look at your supposedly idependent (or 1099) contractors. The IRS might decide they’re actually employees and fine you heavily for misclassifying.   

1099 or what we call “independent workers” make up a substantial component of the modern workforce. According to a 2023 report by MBO Partners, 72 million Americans go to work each day classified as independent contractors- close to 45% of the total workforce. 30 million do their “independent” work in a full-time, every day capacity.

Fortunately, or unfortunately, depending on your POV,  the IRS has put out some new rules for how employers are allowed to classify a worker as a 1099 (non W2) worker. These new rules might impact your business and how you distinguish between a W2 employee and a 1099 independent contractor.   

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 the Mis-Classification Issue

The distinction between independent contractors and W2 employees has been a talking point between employers and various regulatory bodies for as long as I can remember. The IRS doesn’t want it to be too easy for employers to classify a worker as an independent contractor and use that classification to avoid payroll based taxes, mandatory benefit eligibilities, and other administrative and fiduciary obligations that accrue to W2 employees. They have a long history of inserting rules and “guidelines” for employers to use when establishing the “right” classification. They once created a list of 20 factors they wanted employers to consider when making classification decisions. That list got whittled down to 3 more basic but all encompassing factors in 2021. The 2024 guidelines added some even broader considerations under what they call 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 you (the employer) controls how the work is done – Who sets hours of work, when, where and how work is performed. This is not new.
• The worker’s opportunity to generate profit or loss – Which requires you (the employer) to get clear about who benefits when a worker’s skills impact the “profits” (or losses) generated from performing the work. For example, if a worker’s (paid as a 1099) unique contributions will increase your company’s bill rate to a client, the chances are that they are considered a W2 go up. If, on the other hand, a workers specific skills are unrelated to the bill rate to be charged to a customer, the chances that they are a W2 go down.
• The amount and level of skill and initiative is required to do the work – The more independent the worker is from the employer’s oversight of their skills or the personal qualities needed to perform the job, the more likely they are to be considered an independent contractor.  Interviewing and selecting contractors based on processes similar to a hiring process runs the risk of mis-classification.
• 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 they are to IRS scrutiny.
• The worker’s investment in equipment or materials required to do the work – Are the tools the worker needs to bring to the table in order to complete their work provided by you (the employer) or part of their personal tool kit? A contractor who only uses the tools provided by an employer is not a good look to the IRS if the goal is show 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 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 worker otherwise 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 independent contractor 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.

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 wrequirements.   

What can you do to escape IRS scrutiny?

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. They had been paid as 1099 contractors only when assigned to a project – a strategy she believed was 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 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 working as employees of a co-employer partner, not for themselves. 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.

After looking at all options, she chose the EoR option, customizing how it got executed so that each hour of work performed by a worker 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 changes to our internal time tracking system requiring 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 a big value add.

FINAL THOUGHTS…

In summary, for Washington employers who rely on the use of independent contractors or freelancers as part of their staffing model, the new IRS classification guidelines need a second look. Turning your 1099s into W2 employees might be the best option, particularly if you make the process hands free by using a third party staffing agency who offers EoR / pay agent services.