Classifying Workers: Rules, Risks, and Red Flags

How can businesses determine whether a worker should be classified as a W-2 employee or a 1099 subcontractor? Our resident bookkeeping mensch, Paul Rosenblum, breaks down the two main tests—the Common Law Test and the ABC Test—used by states and the IRS to assess worker classification, highlighting the serious tax implications of misclassification and the challenges employers face in navigating these rules. Turns out, bookkeeping isn’t just about numbers—it’s also about dodging financial punches… speaking of which, why did the bookkeeper break up with the calculator? It couldn’t handle their negative balance!

Episodes mentioned: 

- W2 or 1099...The Question That Haunts Business Owners (ep 5)

https://www.buzzsprout.com/2188873/episodes/12836055-w2-or-1099-the-question-that-haunts-business-owners

- W2 or 1099: A closer look (ep 6)

https://www.buzzsprout.com/2188873/episodes/12836054-w2-or-1099-a-closer-look

- 1099 Reporting Changes (ep 21)

https://www.buzzsprout.com/2188873/episodes/13852295-1099-reporting-changes

- QuickBooks no more? (ep 26)

https://www.buzzsprout.com/2188873/episodes/14240698-quickbooks-no-more

Transcript

Episode 54

Testing 1, 2 – Testing 1, 2

There’s one subject that keeps coming back over and over again in my monthly life as a bookkeeper.  I’ve talked about this in episodes 5,6, 21, and 25. That subject?  The classification of workers and how to determine if a worker should be classified as a 1099 subcontractor or a W-2 employee. I’ve spoken about the guidelines, and how to try to determine as a business owner how someone should be classified.  But did you know that there are actual ‘tests’ that states use to determine this?  I haven’t found the specifics on a state’s labor website explaining this to business owners, but the tests actually do exist and are used in every workers’ comp audit. Let’s talk about that today. And I think it’s important that you listen to this one to the very end. This is a shorter episode than usual, but so very important.  I’m Paul Rosenblum. 

 There are two tests that are used to determine if a worker should be classified as a W-2 or a subcontractor. As I have mentioned before, it’s not ‘up to the worker’ to determine how they get paid – it’s up to the state.  In the prior episodes that I have previously mentioned, I talked about the federal guidelines. Guidelines VS a test and what that means is yet another story.  However, the US Department of Labor will work in conjunction with the states, so if the states change the classification of the worker, the states will report that to the IRS for tax reasons which could mean big tax charges and penalties for the subcontractor or employee, as well as the business paying them.  

The ’Common Law Test’ and the ‘ABC Test’ determine if a worker should be classified as an employee (W-2) or a subcontractor. 

The “Common Law Test” which is used by the IRS and 24 states including Washington DC (Maine actually uses a combination of both tests) examines the nature of the employment relationship, focusing on behavioral control, financial control and the type of relationship between the employer and worker.  Let’s look into that further.  

Behavioral Control: Does the employer control where, when, or how work is completed?   

• If an employer tells the worker that they have to come into their office and can’t work remotely, then that moves toward being classified as a W-2 employee.
• If there is any kind of schedule given to the worker by the company without negotiating with the worker, then a W-2 classification is warranted. 
• If there are any rules as to how the work is to be performed, or any meetings or training the worker has to attend by company policy, then a W-2 classification is warranted.

 Financial Control: Does the employer reimburse the workers’ expenses, provide tools/supplies or control the worker’s finances?  

• If the worker lays out money to purchase office supplies, for one example, and the company reimburses them for those supplies which would then become the company’s deductible expense, since the worker is leaving the unused portion of those office expenses behind when they leave, then you are looking at a W-2 classification employee.
• If the company provides tools, supplies or controls the workers’ finances, then a W-2 is in order. A company controls the workers’ finances if the company offers an amount of money that they will pay (maybe with some negotiation for the final figure), but it’s controlled by the employer. 

Type of Relationship: How is the work described in a contract?  Are there employee-type benefits (pension, insurance, vacation pay, 401K, profit sharing)?

• If a worker is offered any type of benefit (even a gym membership paid for by the company, then they should be classified as a W-2 employee, NOT a subcontractor. 

By the way, If you have any questions about any of this, reach out to me at Bookkeepermensch@gmail or go to www.bookkeepermensch.com and contact me there.

The ABC Test: Used by the US Department of Labor and 18 States

Absence of Control: The worker is free from the control and direction of the hiring entity in performing the work.   

•   In other words, If the worker can perform that function remotely, or in the employer’s office (their choice), then a subcontractor classification is warranted. 
• If there is no time clock or sign-in sheet, then a subcontractor classification would be warranted. 

Business is Unusual:  The work performed is outside the usual course of the hiring entity’s business and/or done off-site. 

• More specifically, If the company is in construction, and someone is hired such as a bookkeeper or a website designer, then they would be classified as a subcontracted service, not a part time employee. 

Customarily Engaged: The worker typically works independently in an established trade, occupation or business of the same nature as the work performed in the organization. 

• This is the tricky one.  If you run an accounting firm, and you hire an accountant who works their own hours, from home and/or from your office, should they be an employee or a subcontractor?  They are performing the same work that your firm does, but they are working independently.  If, however, your firm has rules that they must follow before a tax return gets filed, then a W-2 status would be the way to go.   If you, as a business owner, are in a field where there is an industry standard that some workers are subcontractors and some workers are employees, doing the same thing, then that would be the argument for any state audit.  “It is an industry-wide practice, using subcontractors and employees to provide the same service”,  you would say. 

Those are the rules of the two tests. But that isn’t the end of it. Another thing that any auditor will look at is if the people being paid as subcontractors are actually registered as a business.  This would include sole proprietorships, LLC’s (if the state recognizes an LLC, and not all states do), and Corporations.  If someone is an individual being paid as a subcontractor but not registered as a business, then the state auditor will classify that person as an employee, possibly back to when they first started working for that company. It is staggering how many independent contractors don’t even know that they have to register with the state, even if you are a DBA (doing business as- Entity. So, employer taxes with interest and penalties could be a large amount of money depending on the number of years and the number of people involved.  It also could bounce to the individuals for IRS audits to make sure they are filing taxes correctly, if at all. 

By the way, in both tests, the state will by default assume that all subcontractors listed in your books should be classified as W-2 employees until proven that they don’t.  Some states are more aggressive than others though. 

Even if an individual has a contract between themselves and the employer, if the contract does not adhere to the ABC Test or the Common Law test (whichever is used in that state), then the contract would be deemed as invalid as to the subcontractor status. 

If most employers look at these tests literally, I think many company owners or Human Resources departments would realize that many people who are being paid as subcontractors should actually be employees.  

The W-9 forms that people fill out providing their name, address, tax ID number, and name of company and the kind of entity it is (LLC or Corporation or even Sole proprietorship) conveniently does not have a box to check to tell the employer if you have a business certificate or not if you are a sole proprietorship.  So, realistically, how does a company know? Is there a law requiring employers to get a copy of the certificate of business for a sole proprietorship or the state paperwork for the LLC or the paperwork for the S-Corp or C-Corp filing?  Not that I can find. Is the process just designed to fail? If you call the state and ask their advice, they will read to you different guidelines in the tests for you to make your decision. Then if you make the wrong one and you get caught, you will pay penalties and interest.  Just to give me something more to do (like I really need that) – I’m thinking of requiring the individual to provide to me their state business certificate before I pay them as a subcontracted service.  If they don’t or can’t provide that, then they will be paid as an employee.  And then the owner will be angry at me for costing them more money and maybe losing someone if they do not want to be on payroll.  As I have said before, your bookkeeper = a Human Punching Bag.  However, I’m Rocky Balboa in Rocky 3 fighting Clubber Lang for the second time. I’ll survive for another day. And another, and another. I’ll be bruised for a while but will bounce back up for another day to write about my experiences for this podcast.  

I’m going to ice my upper torso now ---   I’m Paul Rosenblum.