We're increasingly living in a 1099 or gig employment economy, and although there's no doubt that employing independent contractors has financial benefits, managing payroll for the 1099 economy can be tricky. But even as the complexity of payroll is increasing, it remains at the core of human capital management, which makes it more important than ever to ensure your organization fully understands the implications and requirements of employing independent contractors.

Just in time for National Payroll Week, here's what you should know to help ensure your business is compliant.

The Risk of Misclassification

If you hire 1099 workers, you don't need to pay overtime, withhold taxes, cover Social Security or Medicare taxes or offer benefits. But the distinction between an employee and an independent contractor is not always clear, and some organizations misclassify by accident.

The Department of Labor (DOL) and the IRS have made it a top priority to pursue and rectify misclassifications, so your organization can't afford to be unprepared. If an audit finds you've misclassified workers, not only will you have to pay back taxes and wages, but you could also face extra penalties and fines.

So it's vital to verify that you are clear on the requirements behind 1099 classifications.

New DOL Standards for Classifying Employees

In the past, the classification of independent contractors was based on how much control a business had over how a worker did their job. For example, if workers at a call center could work from home at their own hours, the business could classify them as independent contractors. But on July 15, 2015, the DOL released new guidance for classifying an individual as an independent contractor or an employee based on the following six "economic realities:"

  1. Can workers increase their earnings through their own managerial skills such as by hiring subcontractors? If the only way they can increase their earnings is by working more hours, this weighs in favor of the individual being an employee.
  2. Are workers making their own investment in the project comparative to your own investment? Is it significant compared to the employer's own investment? This is a sign they're independent contractors.
  3. Will the work be temporary or permanent? Long-term work suggests they're an employee.
  4. Does the work require specialized skills and initiative? Do they have the ability to use their special skills independently? If so, this weighs in favor of the worker being an independent contractor.
  5. Is the work performed by the individual an integral part of your business? If the work is necessary rather than a side project, the workers are more likely to be considered employees.
  6. How much control do you have over them? While this remains a factor, it is no longer the most important determination.

If you decide to classify workers as 1099 workers, you should work with your HR department to document how you made the decision aligned with the DOL's six economic realities.

Fixing a Mistake

If it looks like a business misclassified workers in the past, the IRS, which should be noted has its own test for determining independent contractor status, has created a program to fix the error — the Voluntary Classification Settlement Program. To be eligible, the business must have filed all necessary 1099s for misclassified workers over the past three years, and you (or the business) must have consistently treated the workers as independent contractors. Also, you cannot be currently under a payroll audit, by the IRS, the DOL or a state agency related to the classification of employees, although you're still eligible even if you're under an audit for other reasons.

If so, you file Form 8952 to tell the IRS you'll be treating the misclassified workers as employees from now on. You also have to pay 10 percent of the employment tax that you should have paid in the most recent tax year, as determined under section 3509 under the Internal Revenue Code. The IRS will not charge any interest and penalties on the amount you owe. This is a fraction of what you'd pay if you were audited and the IRS found misclassified workers.

Payroll for the 1099 economy has only gotten more complicated. Not only do you need to keep up with the constantly changing local, state and federal payroll regulations, you have to keep track of the classification rules for 1099 employees. So as the 1099 economy continues to grow stronger, ensuring your payroll for the 1099 economy is compliant should be a top priority for financial leadership as these workers potentially become a larger part of your workforce over time.

Tags: Payroll