The employer’s and their respective contractors’ relationship may drastically change at any point in time. For example, a contractor with whom you have collaborated several times before, but now want them to join you as an employee. 

Now, if you ever misclassify an employee and try to reclassify them under the recent DOL contractor rule, that can become a problem. Since you have labelled them as a worker instead of an employee, you must convert the contractor to an employee. 

This article guides you through a step-by-step process for conversion, along with key insights on its legal considerations, salary adjustments, and other dynamics such as taxes and benefits. Additionally, discover how Payoneer Workforce Management helps businesses with comprehensive workforce management. 

Who are 1099 contractors and W-2 employees?

Before jumping straight to the differences between the two, you need to understand what is meant by a 1099 contractor and a W-2 employee. Let’s decode each of them and understand what features, benefits, and tax obligations they entail. 

1. 1099 Contractors

Professionals with specialized skills who offer services on a contract basis are typically classified as 1099 contractors. These individuals work independently, manage their own time, take on assignments on a project-by-project basis, and are responsible for handling their taxes and benefits.

Essentially, anyone receiving services from these independent workers must report the payments using Form 1099-NEC (Nonemployee Compensation).

Key characteristics of 1099 contractors include:

(a) Control over their work schedule
(b) Classified as self-employed since they manage their taxes
(c) Engagement in work on a per-project basis
(d) Ineligibility for employee benefits such as health insurance, retirement plans, or paid time off.

Advantages of 1099 contractors: 

• They operate in a flexible work setting, allowing them to decide both their work hours and location, which also reflects the level of control they have over their projects. 

• Because they can collaborate with multiple clients, their income streams are more diversified, often resulting in higher gross earnings than those of many other professionals.

• They are eligible for specific tax deductions, which enable them to deduct certain business-related expenses from their taxable income.

• They have greater chances to broaden their skill set, ranging from project operations to advanced technical expertise.

2. W-2 Employees

They are full-time employees of businesses or institutions who fall under U.S. tax laws. 

Any business manager/founder involved in a trade who provides compensation, whether in cash or noncash, adding up to $600 or more annually, for an employee’s services, is required to file Form W-2 for that employee if:

(a) Social Security, Medicare, or income taxes were withheld, or

(b) Income tax would have been withheld had the employee claimed only one withholding allowance or not claimed an exemption on Form W-4 (Employee’s Withholding Allowance Certificate)

Key features of W-2 employees are: 

• They work on schedules defined by their employers.
• They receive benefits such as health coverage, retirement plans, and compensated leave.
• Employers of these employees are responsible for withholding Income Taxes, Medicare, and Social Security contributions from their wages. 

Advantages of W-2 employees are: 

• The professionals enjoy consistent income and financial stability
• Holistic employee benefits include healthcare, retirement solutions, skill enhancement, and paid leave. 
• Beyond the basics, employees can file for unemployment insurance, disability coverage, and other benefits. 

Dissimilarities between 1099 contractors and W-2 Employees

Comprehending the distinction between 1099 contractors and W-2 employees is crucial when you are going for a 1099 to W-2 conversion. 

This is because a misclassification may lead to penalties and interest from the IRS and the Department of Labor.  Here are the key dissimilarities between the two:

1. Financial tax implications

Tax Documentation: 

• Contractors: Independent contractors are commonly issued a Form 1099, which outlines their earnings for the year. Unlike employees, they are responsible for handling their tax filings and making their tax payments. 
• Employees: Salaried staff receive a Form W-2, which includes a detailed breakdown of their salary and the taxes already withheld by the employer, making it straightforward and less manually intensive.

Tax Liabilities:

• Contractors: Taxes aren’t automatically deducted from their pay. Instead, they must calculate and submit estimated tax payments, usually quarterly, on their own as instructed on the official IRS site. 
• Employees: The employers handle tax withholdings directly from each paycheck, reducing the risk of late payments or underpayment.

2. Job safety and working terms

Nature of Work Relation:

• Contractors: They are usually brought on for short-term assignments or specific projects and do not have the ongoing commitment that permanent employees typically have.
• Employees: They become part of the company’s long-term workforce, which often provides them with a greater sense of job security.

Policies of Termination:

• Contractors: Their engagement is linked to specific projects or time-bound contracts. This means their services can end with little notice once the project concludes or if the contract is terminated early.
• Employees: Most employees are protected by internal company policies, such as formal notice periods or severance guidelines, which help guard against sudden termination and provide more job stability. 

3. Flexibility and autonomy

Work Style and Control:

• Contractors: One of the key appeals of contract work is the ability to set your hours and decide where and how to work. 
• Employees: They are bound to follow a fixed schedule laid out by the organisation.

Choice of Projects:

• Contractors: Since they aren’t tied to one employer, contractors have the liberty to accept or reject assignments.
• Employees: Their assignments and duties are typically assigned by their manager or team, leaving little room for choice or shifting projects based on personal interests.

4. Advantages and remuneration

Perks of the Job:

• Contractors: Though they may earn a higher hourly rate compared to employees in similar roles, it is also their responsibility to plan for health insurance, retirement contributions, or paid time off.
• Employees: In addition to a regular salary, employees are often eligible for benefits such as health coverage, leave entitlements, pension contributions, and other company-sponsored perks.

5. Legal safeguards

Labor Rights:

• Contractors: Since they are not formally classified as employees, contractors rely on their contract for legal recourse and are responsible for negotiating terms that protect their interests.
• Employees: Full-time workers are protected under employment laws that enforce fair wages, overtime compensation, anti-discrimination measures, and leave entitlements.

How to convert from a 1099 contractor to a W-2 employee

Converting a 1099 contractor to a W-2 employee has its benefits, like 

(a) Better adherence to regulatory compliance

(b) Firm control over your employees streamlines the process and boosts productivity 

(c) Easy talent retention as your employee gets benefits 

(d) Predictable overhead costs in terms of regular wages to the W-2 employee 

How you convert a contractor to employee matters. However, the conversion must be carried out through a thorough process to avoid any misunderstandings or legal issues. 

Given below is a complete guide for your understanding (This content is for informational purposes only and does not constitute legal advice.):

• Outline the role: If the former contractor is open to transitioning into a full-time role, it’s essential to provide a clear job description. 

This should outline the job title, reporting structure, FLSA classification (exempt or non-exempt), and a summary of the responsibilities the individual will take on as an employee.

• Settle the salary: Be prepared for a conversation around compensation. Since contractors typically factor in their own taxes and benefit expenses when setting their rates, their expectations may differ from what you’re planning to offer as a direct employer. 

Converting a contractor to full-time employee salary should reflect both the market rate for the role and the value of the experience and skills the individual brings.

• Communicate expectations before you sign the documents: Many independent contractors choose that path for the flexibility and autonomy it offers in terms of hours and assignments. 

As they transition to an employee role, it’s essential to clarify whether they’ll be expected to follow a set schedule, utilize the company’s timekeeping system, or obtain approval before working overtime. 

Openly discussing these expectations in advance can help you make a smooth transition and prevent potential misunderstandings about the changes in their responsibilities.

• Be consistent: Maintain consistency in your onboarding process. Even if the contractor has been working with you for some time, it’s still best to follow standard new hire procedures. 

This includes gathering a resume and application for their file, conducting a background check if it’s part of your usual practice, and completing all necessary paperwork, such as a signed offer letter, I-9, and W-4. 

Even if they’re already acquainted with the work, offering an initial induction phase similar to that of other new employees can support a smoother transition and help them align with their new responsibilities as a formal team member.

• Break the ice and build relationships: Many contractors don’t give time to offices, which hampers the opportunities to build a relationship with you (as an employer) and your team. 

An ice-breaking session or coffee breaks might allow that opportunity to help you understand your contractor-turned-employee in the long run. 

How Payoneer Workforce Management can help

Payoneer Workforce Management platform helps streamline onboarding, payroll, invoicing, contractor payments, and more. 

With support in over 160 countries and 70 currencies, our platform helps you engage global talent without setting up local entities. 

Book a demo today to understand how Payoneer Workforce Management may help streamline hiring and support compliance efforts globally.

FAQs

1) What are the consequences of misclassification between 1099 contractors and W-2 employees?

There are several penalties and consequences in that case, which can be laid down as follows:

• You will be held liable for failure to pay overtime and minimum wage under the FLSA and applicable state wage laws.
• Penalties for failing to withhold and remit state and federal payroll charges
• Misclassified workers may be entitled to receive or participate in an employer’s employee benefits, including pension and other retirement plan coverage, health insurance plan coverage, paid leave allowances, and severance pay, among others.
• Misclassification may also fail to provide required protections to individuals under state and federal anti-discrimination laws.
• You can face legal claims, as you failed to provide protected leave. 

2) Can I convert a 1099 contractor to a W-2 Employee?

It’s possible to reclassify a 1099 contractor as a W-2 employee. The first step is to review your list of independent contractors who have worked with you during the tax year. Once identified, you can begin the transition by following the appropriate legal and tax guidelines to stay compliant with employment laws and IRS regulations.