According to the Internal Revenue Service, there are only two employment types: independent contractors (1099-employees) and regular employees (W-2 employees). Who pays which taxes is determined by this legal distinction. Let’s consider how to determine whether to hire someone as an independent contracting vs employing.
How to determine hiring status
From the IRS website we read,
The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done. . . You are not an independent contractor if you perform services that can be controlled by an employer (what will be done and how it will be done).IRS Website: “Independent contractor defined”
You can see that the central issue is the level of control that the employer exerts. If the employee is truly operating independently with little influence from the employer, then employing as an independent contractor is fine. But when the employer directs activities, such as having meetings to discuss how marketing or therapy is conducted, then it is best to think in terms of a W-2 employee.
If in doubt, talk with an attorney. It is important to classify employees correctly. The fines for misclassifying are quite high.
In the startup phase, it is not unusual that an owner will hire only independent contractors. (See: How therapists get paid in private practice.)
Doing so allows the owner to delay the formation of a corporation. If the beginning is gradual, there are not many advantages to forming a corporation right away. Starting up and maintaining a corporation has some cost. Delaying these costs may make sense.
Additionally, tax rules for independent contractors are simpler than for W-2 employees. That may work well when starting up, especially if the early employees tend to only work a few hours per week.
Of course, the hope is that caseloads grow beyond a few hours. We want our part-timers to eventually drop other employment commitments. When they do, we should consider converting them to W-2 employees.
When to convert
It is usually wise to convert your independent contractors to W-2 employees when they do not have another employer. Additionally, some owners will establish policies that specify when the transition from contractor to employee occurs. Sometimes the conversion happens after a specific time of period, say six months. At other times, the conversion may occur after meeting a certain threshold, say after two months with over 80 sessions. Consistency is helpful here.
Becoming a corporation
And of course, at some point, you will doubtless grow large enough to transition your organization into a corporation. Once this occurs, the owner then becomes a W-2 employee of his or her own corporation.
At this point, the owner may consider using a payroll service. This service will help with managing payroll deadlines and processes and the taxes and deadlines required.
Other things to think about
Independent contractors often view their relationship with the organization quite differently from W-2 employees. They may see themselves as self-employed. And sometimes they view the practice “owner” as a landlord and not a boss. They are merely renters of space. And of course, that may be exactly the way the owner sees the arrangement as well. If so, then all is well. But if not, then there may be tension. The owner’s vision makes a big difference in these decisions.
If you anticipate growing to where multiple full-time employees regularly work together toward common goals, you may want to bypass the independent contractor phase altogether. If so then hire people as W-2 employees right from the first. The more active you intend to be as a manager, the more you will want to hire people as W-2 employees.
When I began, my first employees where independent contractors. We then grew to where everyone dropped other employment and switched to working full time with us. At that point, we decided to convert all to W-2 employees. Our accountant helped us convert the percentages we paid people to be roughly equivalent to the old independent contractor system.
We made this conversion because we recognized the need for more direction, guidance, and support. As an organization, we were growing and our employees were dropping other affiliations. They were acting like employees. We needed to pay them then as W-2 employees.
We explain the financial implications of our system in this way:
Clinical staff pay is based on the gross receipts collected each month. This becomes the basis for the next month’s paychecks on the 15th and the 30th.
To compare our system to one that treats you as an independent contractor (IC), add about 10 percent to the out-of-pocket costs of the IC package. This is so because of the differences between how an independent contractor’s taxes are handled from a W-2 employee’s.
An independent contractor must pay 100 percent of the social security and Medicare taxes. That adds 7.65 percent to the IC’s tax bill every year. As your employer, the company (CCC) pays the 7.65 percent plus some other taxes; CCC also offers employees a 3 percent match for their retirement funds. This plus the other benefits CCC offers are more than a 10 percent value over what an independent contractor would pay.
In my experience, the emotional transition to a W-2 employee was difficult for some. Some were unable to adjust. They left within a year or two. Accepting that they now had a boss was just too much. However, for most of our clinicians, they transitioned well. And many came to like it very much. They liked the shift of responsibility for some taxes to the company.
Use your accountant to help you with these calculations. Mistakes can hurt the company and its employees.
[I am not an attorney nor an accountant. This is not intended to be legal or financial advice. Please consult with a qualified attorney or accountant before taking action.]
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