How do you make sense of worker classifications? When you’re a small business owner, you may employ several W-2 employees, but you also likely work with at least a few (and sometimes a lot of) independent contractors. How you file taxes for those workers is really important, because if you do it wrong, it can come back to bite you. 

So, how do you know which is which and who gets classified as what? What are the best practices for business owners to follow on worker classification? 

I recently interviewed my very own CPA, Larry Rubin, of Aronson LLC, about a handful of small business finance questions, including worker classification. From determining what’s “easier” to figure out whether or not you really need to issue 1099s (and how), hear what Larry had to say about all things worker classification in the interview below. 

(And let me tell you—if you’re in the market for a new CPA, Larry’s the guy. I’m happy to share him!)

Brandon Green: Hello, everyone. Today I have Larry Rubin with Aronson in Rockville, Maryland, my CPA. I’m excited to have him on board. He works with clients all over the country. Today we’re going to be talking about worker classifications, 1099, W-2; all that sort of stuff. Larry, welcome.

Larry Rubin: Thank you so much.

BG: Let’s talk about this. I think paying people as independent contractors is certainly, for an employer, can feel like an easier thing to do. Maybe even for the person getting paid. But there’s a lot to this. It’s not exactly straightforward, and you can get in trouble if you don’t do this right. What’s your thought on this?

LG: An independent contractor is a viable model if you do it right, but if you don’t, there’s a whole host of laws that could be problematic. It’s not just Internal Revenue Service, the tax code, but there’s also the Department of Labor, Workers Comp Insurance, state unemployment—any type of labor-related laws that would get in the way, because the presumption is that businesses that treat their workers as employees, those employees have their rights better protected than if they’re an independent contractor. 

BG: And there are some best practices you recommend. If you’re going to go the contractor route, then there’s some things you should make sure from a document standpoint you’re taking care of. What are those things?

LG: The first thing to bear in mind as far as an independent contractor relationship is, it truly has to be facts on the ground that that is the relationship. 

To think of it in easier terms, imagine if your home air conditioner broke and you called a repair guy. That is a classic independent contractor. They’re coming with their own tools. They’re doing something that’s not in your wheelhouse. They’re telling you when they can come. They do the job how they do it. The only thing that you’re holding them to account for is simply the end result. Did they fix it or not? 

It’s the same thing. When you are engaging the services of an independent contractor, it is a business-to-business relationship. It’s not your business-to-employee relationship. That’s extremely important. The things you want to do, and this is not an exhaustive list, but first and foremost, is you want to get a W-9 from the contractor. That’s the form in which the contractor is writing down their tax information and tax ID number and what their business classification is, whether it’s self-proprietorship, corporation—what have you. That is evidence, first and foremost, that the business owner is holding him or herself out as a separate business—because a W-9 is not something an employee would fill out. Employees fill out a W-4. That’s for withholding. The W-9 is simply for reporting for 1099 information. 

You want the independent contractor to invoice you. So, it’s not just, a guy says, “Hey, you owe me $500,” and you write the check. You want an actual invoice that you pay off of—no different than any other contractor that you do business with. If there is a contract that you’re signing with them, the contract is either their contract where it’s clear that it is them engaging in an independent contractor relationship, or if it’s your contract, it has teeth to it that basically, among other things, says that if any party takes a position that is contrary to this relationship, that that part will indemnify the other. 

It basically is a way to say, “Hey, independent contractor, if you do something crazy like file for unemployment benefits or complain to the Department of Labor that I’m not paying you overtime, this contract says, ‘Wait a minute. It’s an independent contractor relationship. You don’t get these things, and by the way, you have to pay me back for the attorney costs I had to defend all this.’” Anything to do with contracting something, you absolutely must work with your business attorney on this. This is not a do-it-yourself thing. 

BG: They also need to have some freedom and can’t be, “Clock in every day at 9 and be out at 5.” That is not a contractor relationship, right?

LG: Right. While there may be certain external constraints such as they come to work in your office and the office building is locked between certain times and you don’t want to give them a keycard, then yes, there are core hours that are outside of your control. Certainly, any type of behavioral control, as far as schedule setting and micromanaging—things like that—you want to avoid. 

In essence, you’re saying, “Here’s the end result I want. How you do it is how you do it. I’m not going to dictate every minute step of how you need to do something because hey, you’re in your own business. You’re a hired gun. You know how to do it.” 

Financial controls is another one. Does the individual have an opportunity to make both a profit and a loss? If it’s something where they’re being paid on an hourly basis and that’s it, there’s really not so much of a business opportunity. Going back to the air conditioning example, if somebody quotes that it’s going to take an $89 tune up for your HVAC when they come in the spring, it doesn’t matter whether they’re there for five minutes or five hours. That’s the price. So, in that example, the guy coming out has the financial control of whether they’re going to be able to make money, not make money, and they’re setting the price. 

The other important thing is that you do not want to have a mix of employees and independent contractors doing the same thing. The issue comes in where the presumption is that if you hire an independent contractor, and you have employees who are similarly situated—they’re doing basically the same thing, the same kind of responsibilities—there’s a strong presumption that that independent contractor is misclassified and really should be treated as your employee. 

BG: Can you pay somebody both W-2 and 1099 over the course of the year? Maybe they are employed with you, but then they also do a side project—can you do that?

LG: It’s possible, but it is strongly not recommended. That’s a really big flag. If someone is your employee, everything you pay them should be run through payroll. Any type of side project, it’s still for the business, and you’re still telling them what to do and how to do it. For that, they should be on W-2. 

Now, it is possible that you have a worker who is a W-2 employee and then their circumstance changes where they want to go out on their own business and instead of being your employee, they want to be an independent contractor and continue to work for you. That is okay. It happens. So, you can have a situation where a person gets a W-2 for, let’s say, January to May 31, and then the nature of the work relationship changes and on June 1 to December 31, they’re a 1099. In that situation, you have got to have your I’s dotted and your T’s crossed to make sure that they are really, truly an independent contractor. 

BG: A final question on this is, I know at the end of the year, you need to, as an employer, send out 1099s and W-2s and that requires you to have some information. We had a situation recently where we just couldn’t reach someone that we had paid as a contractor for a relatively short gig. It was like $2,000 and we didn’t get the W-9, unfortunately, in the moment, and never could reach them again. Is that a problem for the business owner then? We were not able to issue them a 1099. What do you do in a scenario like that?

LG: It is problematic if the IRS were to come in and look. There are two ways these things are found out. One way is that the IRS does a general audit of your business, and they are very, very hot on this worker classification issue. And they will want to see all the 1099s you issued, all the W-2s, and the general ledger showing all of the individuals you paid to try to figure out who’s what, who’s who. If there’s no 1099 issued, then the IRS will assert a penalty for not filing it. 

So, the best business practice is, first and foremost, get the W-9. Even if the contractor says, “Well, I’ll get it to you next week,” it’s like, “Okay, I’ll pay you as fast as you get me that form.” But do not write a check until that form is complete. 

You may also have a situation where the W-9 itself, there may be some issue with it where they miswrote their social security number, accidentally or otherwise. As long as you’re filing a 1099 based on what that person gave you on that W-9, which is signed by the contractor, then you’re okay. That is evidence to the IRS that you have exercised reasonable business care to get this information.

BG: And the threshold is low on the dollar amount, right, that you have to actually issue these documents. What is it, $500?

LG: It used to be $500 many years ago. It’s now $600. If you’re paying anybody—and this is aggregate. This is not, “Did I pay anybody $600 at any given time?” It could be a bunch of little checks that add up to the $600. Once you’re at that threshold aggregated for the year, you do need to file a 1099. New for 2020 filing is the 1099-NEC. It used to be that everything would go in a 1099-MISC. The IRS changed that, because they want the 1099-NECs in the IRS hands by January 31 in their effort to better match up these 1099s to, hopefully, the individual’s tax returns if they reported the income. 

BG: Thank you, Larry. Appreciate it. If people wanted to reach out to you, what’s the best contact information?

LG: Best way to reach me is call me. My number is 301-222-8212. Or feel free to email me at LRubin@aronsonLLC.com.

BG: Thank you, Larry, for the valuable information today. 

LG: Thank you.

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About Brandon Green

Brandon is a businessman & entrepreneur who founded a billion-dollar real estate enterprise. He is now focused on speaking, consulting, and investing in people and scalable ideas.

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