Can a Single-Member LLC Have 1099 Employees?
Hiring for your single-member LLC? The difference between a contractor and an employee is determined by law, not preference. Get the facts to avoid costly errors.
A single-member limited liability company (SMLLC) can engage other individuals or businesses to provide services. However, the term “1099 employee” is a misunderstanding of worker classification. A worker is either an independent contractor, who receives an IRS Form 1099-NEC for payments of $600 or more, or an employee, who receives an IRS Form W-2 detailing wages and tax withholdings.
The distinction is not a choice but a matter of legal and tax definition based on the nature of the working relationship. Federal and state agencies have specific criteria to determine how a worker must be classified. Misclassifying a worker can lead to significant financial consequences, so it is important to understand the rules before bringing on help.
Understanding Worker Classification
The Internal Revenue Service (IRS) and state labor departments use the “right to control” test to distinguish between an independent contractor and an employee. This concept centers on whether the business has the right to exercise control, not whether it actually does. The IRS groups the evidence for this determination into three categories.
Behavioral control examines who directs how the work is done. If the business can dictate the methods, processes, or sequence of tasks, the worker is likely an employee. This includes requiring specific training, setting a rigid work schedule, or mandating certain techniques. An independent contractor determines their own methods for completing a project.
Financial control focuses on the business aspects of the job. This includes whether the worker can realize a profit or loss. An independent contractor often invests in their own tools, pays for their own business expenses, and is free to work for other companies. In contrast, an employee is paid a regular wage, has business expenses reimbursed, and uses tools provided by the employer.
The relationship of the parties looks at how the business and worker perceive their connection. A written contract defining the relationship as an independent contractor is evidence, but it is not the only factor. Other considerations include whether the business provides benefits like health insurance or paid vacation, which indicates an employment relationship. A permanent or long-term engagement suggests employment, while a project-based relationship points toward independent contractor status.
Requirements for Engaging an Independent Contractor
If a worker meets the criteria for an independent contractor, the SMLLC owner must take specific administrative steps before work begins. These actions establish a clear record of the relationship and ensure tax compliance.
A requirement is to have a well-defined written agreement. This contract should outline the scope of services, payment terms, and the project’s timeline or deliverables. The agreement must state that the worker is an independent contractor responsible for their own taxes, insurance, and business expenses.
Before payment, the SMLLC must get a completed Form W-9, “Request for Taxpayer Identification Number and Certification,” from the contractor. This IRS form collects the contractor’s name, address, and Taxpayer Identification Number (TIN), which can be a Social Security Number (SSN) or an Employer Identification Number (EIN). The W-9 is kept for the SMLLC’s records and is used to prepare Form 1099-NEC at year-end for payments of $600 or more.
Requirements for Hiring an Employee
If a worker is an employee, the SMLLC owner has more extensive administrative tasks than for a contractor. This process involves registering as an employer and setting up a system for payroll and tax obligations to comply with employment laws.
A first step is for the SMLLC to get a federal Employer Identification Number (EIN) from the IRS. An EIN is required once the business hires its first employee, even if it previously used the owner’s Social Security Number. The EIN is used on all employer-related tax filings and identifies the business as an employer to the federal government.
The new hire must complete paperwork before starting work. The employee fills out Form W-4, “Employee’s Withholding Certificate,” to direct the employer on federal income tax withholding. Both the employee and employer must also complete Form I-9, “Employment Eligibility Verification,” within the first three days of employment to verify the worker’s identity and authorization to work in the U.S.
Setting up a payroll system is another requirement. This system calculates and withholds the employee’s share of Social Security and Medicare (FICA) taxes and federal income tax. The employer must also pay its matching share of FICA taxes and federal unemployment (FUTA) taxes. The process includes state-level requirements, like registering for and paying state unemployment insurance (SUI) taxes.
Risks of Worker Misclassification
Misclassifying an employee as an independent contractor exposes an SMLLC to significant financial liabilities. Government agencies like the IRS and state departments of labor audit businesses for compliance. If an audit finds a worker was improperly classified, the consequences are severe and apply retroactively for the entire period.
The most immediate financial impact is liability for back employment taxes. The business will be responsible for the employer’s share of Social Security and Medicare (FICA) taxes that were not paid. The business may also be held liable for the employee’s share of FICA and federal income taxes that should have been withheld, creating a substantial tax debt.
In addition to back taxes, government agencies impose penalties for failing to pay taxes and file required forms, like Form 941. These penalties can be a large percentage of the unpaid tax liability. Interest will also accrue on both the unpaid taxes and the penalties from their original due date.
The financial risks extend beyond taxes. A reclassified employee may be entitled to retroactive benefits under labor laws. This could include claims for unpaid overtime wages under the Fair Labor Standards Act (FLSA) and liability for not providing workers’ compensation insurance. These issues can result in further payments, legal fees, and settlements.