A common challenge most small and medium sized businesses face is determining how to classify an employee. For small and medium sized businesses, cost is an ever-present concern and one of the biggest costs is that of employees. As such, knowing how to classify employees—whether as a W-2 worker or 1099 independent contractor—is essential.
What’s the difference?
A W-2 employee is a worker who receives a regular wage and employee benefits, such as health and dental insurance or unlimited paid time off, from the company. W-2 employees are also entitled to state and federal protections along with specific federal or state benefits. These benefits include tax withholdings, workers compensation, sick leave, minimum wage, and more.
On the other hand, a 1099 employee is an independent contractor who is considered self-employed. Unlike a W-2 employee, an independent contractor must file a 1099 form for their tax return. They are paid according to their contract and do not receive the same benefits or protections as a W-2 employee.
However, there are numerous benefits to hiring a 1099 independent contractor, including:
- Less overhead and administrative costs;
- Less legal responsibilities as independent contractors are business owners and have their own insurance;
- Access to specialized expertise; and
- Greater employment flexibility as independent contractors are hired for a specific time period or task instead of long-term employment.
Why is it so important?
Small to medium sized businesses need to know how to properly classify their employees. A misclassified independent contractor subjects a business to costly fines and legal fees, negating all the benefits of having a 1099 worker. Also, a misclassified W-2 employee may sue the business for denying them access to benefits, including overtime pay, minimum wage, and more.
For small and medium sized businesses operating in California, misclassification is of a particular concern due to the recent passage of Assembly Bill 5 (AB5), effective since January 1, 2020, which codifies the landmark April 2018 decision in Dynamex Operations West, Inc. v. Superior Court of Los Angeles (2018) 4 Cal.5th 903. In this case, the California Supreme Court ruled that a California worker is always presumed to be an employee and the burden to prove otherwise is on the business. This ruling is codified through the “ABC Test,” a test detailed in AB5 that could potentially reclassify millions of independent contractors as employees.
The “ABC Test” provides three conditions a worker must pass to be classified as an independent contractor. These conditions are:
(a) the worker is free from control and direction from the employer in the performance of services; and
(b) the worker is performing work outside the usual course of the business of the hiring business; and
(c) the worker is customarily engaged in an independently established trade, occupation, or business.
Although there are professions exempt from AB5, independent contractors working in a certain set of exempt professions must still pass a flexible 11-point “manner and means” test, codified under S. G. Borello & Sons, Inc. v. Department of Industrial Relations.
The central principle of these two tests is the same: the more control a business exercises over the way a person works, the more likely that the person is an employee rather than an independent contractor. It is important to note that a written agreement with a 1099 worker stating that they are an independent contractor is not determinative. The label a business places on a 1099 worker is irrelevant if the business cannot satisfy the applicable tests.
In conclusion, the way businesses classify their workers, whether as a W-2 employee or 1099 independent contractor is very important and can lead to serious consequences. Thus, a small and medium sized business must carefully consider whether they satisfy the applicable independent contractor tests before hiring an independent contractor.
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