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Misclassification of employees happens more frequently than you might think, and it can come with a hefty cost to the employer. — Getty Images/NoDerog

Over the past decade, self-employed Americans have become a large and essential part of the workforce. Between 2016 and 2021 alone, the gig economy saw an increase of 31% percent more people enter the industry — equal to about 58 million independent workers. That number is only expected to grow, with the number of U.S. contract employees expected to grow exponentially by 2028 to over 90 million.

As independent professionals continue to grow, it’s important to understand how your business can benefit from working with self-employed contractors and, more importantly, how to classify them to the Internal Revenue Service (IRS).

Independent contractors are also known as “1099 employees,” which comes from the tax form you file with the IRS at the end of the year. Many small businesses consider hiring 1099 contractors over W-2 employees to cut back on costs and avoid legal responsibilities.

However, there are a few big differences between a 1099 contractor and a W-2 employee. As the gig economy grows, it’s becoming increasingly important to correctly classify your workers. Misclassifying W-2 employees as 1099 contractors is a costly mistake that can stop your business in its tracks as you may face hefty penalties, lawsuits or even jail time.

What is the difference between W-2 and 1099 employees?

The line between a W-2 employee and a 1099 contractor may seem blurry, but the most important difference is whether your business must withhold taxes from a worker's payments.

If you classify a worker as a W-2 employee, you are required to withhold social security tax, income tax, Medicare tax and any state income taxes for the benefit of the employee. If you classify a worker as a 1099 contractor, they are responsible for paying federal and state taxes themselves.

The IRS offers the following guidance to help companies differentiate between the two types of workers and properly classify them:

In most cases, a worker should be classified as a W-2 employee if:

  • You control the details of how the work is performed.
  • You provide office space, equipment and supplies for the worker to complete tasks.
  • You provide employee benefits, such as insurance, retirement plans or vacation time.

Workers should be classified as 1099 contractors if:

  • They control when and how they perform their work.
  • They use their own equipment and supplies to complete tasks.
  • They provide services to several different clients who pay them directly for their work.

[Read more: 5 Perks You Can Offer 1099 Workers]

As the gig economy grows, it’s becoming increasingly important to correctly classify your workers.

What are the penalties if you misclassify employees?

Across all industries, between 10% and 30% of employees — roughly several million people — are misclassified as 1099 contractors every year. Classifying employees as independent contractors means a company can avoid paying Medicare, social security, overtime, unemployment compensation, workers’ compensation and various employee benefits, ranging from vacation pay to retirement plans.

Employers who are caught misclassifying their workforce face hefty fines and penalties, which is why it is crucial to correctly classify your employees.

The penalties for misclassifying employees vary based on whether the IRS and Department of Labor (DOL) determine the error was unintentional or not. If your business makes an honest mistake and classifies a W-2 employee as a 1099 contractor, you may face the following penalties:

  • $50 for every W-2 the employer failed to file correctly.
  • 1.5% of wages.
  • 40% of FICA taxes that were not withheld from the employee.
  • 100% of the FICA taxes the employer should have paid.
  • 0.5% of the unpaid tax liability for each month up to 25%, according to the Failure to Pay Taxes penalty.

If the IRS determines you intentionally misclassified employees, it can impose additional fines and penalties, such as paying 100% of both the employer and employee’s share of FICA taxes. The IRS may also charge criminal penalties of up to a thousand dollars per misclassified worker and impose one year in prison.

The government takes employee misclassification seriously, especially with underreported tax liabilities representing 80% of the country’s gross tax gap in the United States.

[Read more: What to Know Before Hiring Gig Workers]

Protecting your business from misclassification penalties

If you’re unsure how to classify your employees, you can file a Form SS-8 to the IRS. They will review the nature of the relationship between the employer and the employee and give you an official determination.

This process can take several months to complete, but it may be worth the wait if you want to hire many workers with the same roles and responsibilities. If you need to quickly determine your workers’ classification, consult with an employment attorney or tax professional before making your final decision.

[Read more: What Is a 1099-K Tax Form?]

CO— aims to bring you inspiration from leading respected experts. However, before making any business decision, you should consult a professional who can advise you based on your individual situation.

CO—is committed to helping you start, run and grow your small business. Learn more about the benefits of small business membership in the U.S. Chamber of Commerce, here.

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