IRS: HOW TO CLASSIFY WORKER IF EMPLOYER FILES BOTH A W-2 AND A 1099-MISC

10 December 2020

IRS website: Form W-2 and Form 1099-MISC Filed for the Same Year (12/10/2020)
On its website, the IRS has discussed what issues an IRS examiner should look at when determining the classification of a worker (as either an employee or independent contractor) when the employer files both a Form W-2, Wage and Tax Statement, and a Form 1099-MISC, Miscellaneous Information, for the worker for the same year.

Background. Generally, an employer is required to withhold income and employment taxes from its employees. (Code Sec. 3402)
When determining how to classify a worker (i.e., as an employee or an independent contractor), the Tax Court looks at various factors including:

1. The degree of control exercised by the principal over the details of the work;
2. Which party invests in the facilities used in the work;
3. The opportunity of the worker for profit or loss;
4. Whether or not the principal has the right to discharge the worker;
5. Whether the work is part of the principal’s regular business;
6. The permanency of the relationship; and
7. The relationship the parties believe they are creating.

No single factor is dispositive, and all facts and circumstances must be considered. The extent to which the principal has the right to exercise control over the worker is the “crucial test” in determining the nature of a working relationship. (Weber, (1994) 103 TC 378, aff’d (1995 CA4) 76 AFTR 2d 95-5782)

If a worker is classified as an employee, then the employer files a Form W-2, Wage and Tax Statement, with the IRS to show the amount of taxes withheld from the employee’s wages. (IRS website: About Form W-2, Wage and Tax Statement)

If a worker is classified as an independent contractor, then the person paying the worker income files a Form 1099-MISC, Miscellaneous Information, to show the amount of wages the worker received, and any income taxes withheld.

Issue. What if an employer files both a Form W-2 and Form 1099-MISC for a worker? How should IRS classify the worker?

Analysis. When the taxpayer files both Form W-2 and Form 1099-MISC for a worker, the examiner should consider whether:

1. The worker was treated as an employee for part of the year and an independent contractor for a separate part of the year (i.e., payments reported on Form W-2 and Form 1099-MISC were for the same services but distinct periods of time during the year).
2. The worker was performing two or more distinct services and the taxpayer considered the worker to be an employee for one service and an independent contractor for the other service (i.e., dual status worker).
3. The payment reported on Form 1099-MISC represented additional compensation to the worker in his capacity as an employee for which he received compensation reported on Form W-2 (e.g., a bonus payment).

These three situations are discussed in detail below:

Worker was treated as an employee for part of the year. IRS Examiners often encounter situations where a worker was treated as an employee for part of the year and an independent contractor for a separate part of the year. The examination of whether the worker should have been treated as an employee for the period of time the worker was treated as an independent contractor is a worker classification issue. The fact that the taxpayer treated the worker as an employee for part of the year does not turn the examination of the period of time the worker was treated as an independent contractor into a wage issue.

Observation. The IRS does not define what a “wage issue” is.

Example 1. The taxpayer treated the workers as employees from January 1, 2019 through June 30, 2019. All compensation paid to workers for this period was reported as wages on Forms 941, Employer’s Quarterly Federal Tax Return, and the taxpayer filed Forms W-2 reporting the compensation paid to the workers for this period. The taxpayer reclassified the workers as independent contractors beginning on July 1, 2019 and continued to treat the workers as independent contractors for the remainder of 2019.

The compensation paid to the workers for the period from July 1, 2019 through December 31, 2019, was reported on Forms 1099-MISC as non-employee compensation in box 7. The workers performed the same services and there was no change in control factors for the period from July 1, 2019, through December 31, 2019.

Since the taxpayer treated the workers as independent contractors for a period of time distinct from the period of time the workers were treated as employees, an examination of the status of the workers for July 1, 2019 through December 31, 2019 is a worker classification issue.

Dual status workers. When a taxpayer files both a Form W-2 and Form 1099-MISC for a worker for the same year, and payments reported on each information return were made during the same period of time, the taxpayer may argue that the worker was performing two separate and distinct services – one as an employee and one as an independent contractor. Examiners must develop the facts to determine whether the workers were truly performing separate and distinct services as an employee and independent contractor.

The examination of whether the worker was clearly performing separate and distinct services, and whether the worker was an employee for Form 1099-MISC services, is a worker classification issue. The facts relating to Form W-2 services would not be considered in deciding whether the worker is an employee for Form 1099-MISC services. If the worker was not performing separate and distinct services concurrently, the issue will be a wage issue, not a worker classification issue.

Example 2. During an employment tax examination, the examiner found the taxpayer filed both a Form W-2 and Form 1099-MISC in the same year for a worker. The taxpayer explained that the worker performed dual services. The worker was treated as an employee for services performed as an auto mechanic. The worker was treated as an independent contractor for services performed as a car salesman. The examiner determined that the worker performed services as an auto mechanic on Monday through Thursday each week and as a car salesman on Friday and Saturday.

As an auto mechanic, the worker was paid an hourly rate of $40 per hour, which was reported on Form W-2. As a car salesman, the worker was paid only a commission for each car sold. The examiner verified the commission payments based on sales records and confirmed these amounts were reported on Form 1099-MISC.

The examination of whether the worker should have been treated as an employee for services performed as a car salesman is a worker classification issue. The fact that the worker was treated as an employee for services performed as an auto mechanic is not relevant to the issue of whether the worker is an employee for services performed as a car salesman. Only the facts specific to his services as a car salesman must be analyzed to determine whether the worker is an employee with respect to services as a car salesman.

Example 3. During an examination of a taxpayer’s 2019 employment tax returns, the examiner found the taxpayer filed both Form W-2 and Form 1099-MISC for several workers. The taxpayer explained that the workers were mortgage brokers performing dual services. The taxpayer considered the workers to be independent contractors for selling mortgages, and employees for the time spent completing the paperwork to process the mortgages. The workers were paid a flat hourly rate for all services; however, the taxpayer allocated the compensation to the workers as 80% for selling mortgages and 20% for completing paperwork. The examiner concluded that completing the paperwork to process the mortgages sold is part of the same services provided by the workers for selling the mortgages. Since only one service is provided, these are not dual status workers. The examination concerns a wage issue because the compensation reported on Form 1099-MISC was for the same services for which wages were reported on Form W-2.

Additional compensation payments reported on Forms 1099-MISC. When a taxpayer files both Form W-2 and Form 1099-MISC for a worker for the same year, and the payment reported on Form 1099-MISC can clearly be identified as additional compensation (such as a taxable fringe benefit), the examination of whether the additional compensation is subject to employment tax is a wage issue. The consideration is whether the payment meets the definition of wages or is excludable under a specific Code section.

Example 4. During an examination of the taxpayer’s 2019 employment tax returns, the examiner found the taxpayer filed both Form W-2 and Form 1099-MISC for several workers. The taxpayer explained that the amounts reported on the Forms 1099-MISC were year-end bonuses paid to employees. Since bonuses were paid to workers for services performed as employees, the bonus payments are considered additional wages subject to employment taxes. The examination does not concern a worker classification issue.

Issue indicators or audit tips.

1. Prior to contacting the taxpayer, the examiner should review the tax returns and Integrated Data Retrieval System (IDRS, a system which enables IRS employees to have instantaneous visual access to certain taxpayer accounts) information to identify potential issues. This may include reviewing Forms W-2 and 1099 filings to identify potential worker classification issues, or whether the taxpayer is filing both Forms 1099-MISC and Forms W-2 for any worker.
2. Compare Forms W-2 to Forms 1099 to see if the taxpayer filed both forms for any worker.
3. Inquire during taxpayer interviews whether they have workers paid both as an employee and contractor.
4. Review the organization’s payables for payments to the same workers for different categories, such as salary and then also as “contract.”