W2 or 1099?

I have seen a trend with many small-business owners in the USA over the last 10 years. They are converting seasonal sources of labor from employees to independent contractors. I understand why they might do this. Often, a business owner can save a lot of money.

Independent workers, such as guides for example, often prefer to be paid as contractors because they receive a larger check, and they can take advantage of the tax code to expense their truck, equipment, and other business-related purchases. But for the outfitter, the conversion from paying W2 employee labor to the 1099 labor of an independent contractor may be good for the bottom line, but it might also be a terrible decision.

Let’s look at some of the responsibilities employers have to their employees (as opposed to independent contractors):

1. Employers are responsible for withholding their employees’ payroll taxes. The tax is based on “wages, salaries, and tips” paid to employees. Payroll taxes are deducted from the employees’ earnings and paid directly to the IRS by the employer. They are typically divided into three categories: Social security, 6.2 percent; Medicare, 1.45 percent; and federal income tax, which varies based on income brackets. There is a cap for Social Security, adjusted annually. In 2020, it was $137,700. Once an employee hits the cap in a calendar year, that tax stops. On the other hand, the Medicare tax increases .9 percent once an employee earns more than $200,000 in a calendar year. Some states and municipalities also impose income tax that the employers are typically required to withhold.
2. Unemployment insurance is another expense required of employers. Two statutes govern this: the Federal Unemployment Tax Act (FUTA) and State Unemployment Tax Act (SUTA). These are taxes paid by employers, not by employees. Unemployment insurance affects seasonal employers the most because it taxes the first $7,000 (FUTA) to $10,000 (SUTA) in a calendar year. In other words, an employer who employs five seasonal guides, each earning $10,000- $20,000 a year, will pay the same FUTA and SUTA tax as an employer who has five full-time, year-round employees.
3. Employers also pay workers’ compensation insurance. Workers’ comp is intended to protect business owners and employees in the event of injury or illness caused by the job. It pays for lost wages, medical expenses, vocational rehabilitation, and death benefits. This protects the employer because comp becomes the exclusive remedy against the employer for an employee who suffers a loss. It’s also a system for prompt payment of bills and replacement income for the injured.
4. Some states require employers to provide paid time off for employees.

Before you switch from paying your guides as employees (W2) to contract workers (1099), make sure you know all the risks. A tax attorney and insurance agent can help you make an informed decision.

Not so Fast
When reviewing these four issues, it’s easy to recognize a few advantages to converting workers from employees to independent contractors. There are, however, hidden landmines, which are further complicated when you consider the statutes for that classifying a worker as "employee" vs "independent contractor" vary widely by state. If a business owner makes a mistake and reclassifies employees to independent contractors when it is not permissible, the business owners can be responsible to pay the withholdings and match-plus penalties—not to mention the fines and criminal charges. 

A huge financial disaster can also occur if the owner makes a mistake on workers’ compensation and an independent contractor becomes chronically sick or injured on the job. While the state may allow the person to be characterized as an independent contractor, the workers’ compensation statute may contain a broad definition of “employee,” which could require guides who are independent contractors to be covered by the business owners’ workers’ comp policy. Further, if a business owner makes a mistake and fails to purchase workers’ comp insurance, and an independent contractor suffers a chronic illness or injury that is related to the job, the guide may seek financial compensation and money damages from the business owner.

And to hit home, understand that the failure to acquire comp also may “pierce the corporate veil.” That’s the term used when a judge allows the employee to collect from a business owner’s personal assets. Obviously, this is something you want to avoid!

Other potential issues include independent contractors who are domiciled in other states, the Fair Labor Standards Act which governs overtime pay, and outfitters who provide services in multiple states. If your outfit deals with these three issues, I advise that you seek local legal counsel and advice from a competent insurance agent before switching from employees to independent contractors. If you are already using independent contractors, you need to review your decision with a lawyer and an insurance agent to make sure you and your family are not getting a short-term benefit with big exposure to risk.

In states where the definition of an employee is ambiguous, take the safe route and purchase an appropriate insurance policy that covers your business’s independent contractor workers.

Michael Van Tubergen is a lawyer from Wisconsin and a hunter who has represented clients in the outdoor-sports industries. The information provided in this article is not legal advice. Legal advice will always vary depending on each client’s unique situation. All information is offered for informational purposes only.

From the “Law and Liability” column that ran in the Summer 2020 Issue of Guidefitter Journal.