1099 Contractor to W2 Employee Transitions

W-2 and employment tax forms

Are you ready to transition 1099 contractors to W2 employees? Here is a great way to determine the mandates that are recommended per state guidelines. 

Being a small business owner, you might find it necessary to change the status of your independent contractors to W-2 employees. This transition offers greater control, consistent human resource practices, better team building efforts, and compliance with legal obligations. Whether you’re transitioning contractors to employees for better alignment with your company’s needs or to understand federal and state mandates or avoid misclassification penalties during a brutal state audit, understanding what needs to be taken care of is a crucial step in running your organization.

I have been working with clients who share that having contractors leaves them wondering if the contractors themselves have buy-in to the mission, vision and values of their company. They see more absenteeism, more non-productive work time given and more distractions from being on their phone or social media. Sometimes, you might even encounter people who don’t show up to fill the gap because they don’t need to. “You’re not really my boss, so what does it matter to you?” When you have a dedicated W2 employee, they have more “skin in the game” as far as building your business stronger and more desire to make it a great place to work. They are more engaged with the vision of the company, want to create exceptional referrals that drive revenue and have a desire to feel recognized and wanted by their employer. The engagement turns into a force of nature. 

I want to help you make the decision (or not) to make the next steps if you are in this situation. Here are some best practices to follow if you are considering this move.

1. Determine Proper Classification

Before transitioning contractors to W-2 employees, confirm that the reclassification is necessary. The IRS provides three key tests to determine if someone is an independent contractor or an employee:

  • Behavioral Control: Do you have the right to direct how, when, and where the worker performs the job?
  • Financial Control: Do you control the business aspects of the worker’s job, such as how the worker is paid and whether expenses are reimbursed?
  • Relationship Type: Does the relationship appear permanent, and are benefits like health insurance and retirement offered?

If these factors lean toward the company exercising more control, the worker should likely be classified as an employee.

2. Understand Federal Legal Requirements

Transitioning contractors to employees means adhering to federal labor laws, which govern how employees must be treated and compensated.

Federal Income Tax Withholding

Once reclassified as W-2 employees, you are required to withhold federal income tax from their pay. The process involves:

  • Form W-4: Each new employee must complete a W-4 form to determine the correct amount of federal income tax to withhold from their paychecks.

Social Security and Medicare Taxes

  • Employer Contributions: As an employer, you must pay part of your employees’ Social Security and Medicare taxes, while independent contractors are responsible for the entire amount under self-employment taxes. You’ll need to withhold the employee’s share and remit both portions to the IRS.

Unemployment Tax (FUTA)

  • Once your contractors are reclassified as employees, you must pay federal unemployment taxes (FUTA), which fund unemployment compensation for workers who lose their jobs.

3. Comply with State-Specific Laws

Each state has unique employment laws and tax obligations for W-2 employees. It’s essential to understand the following state-level requirements:

State Income Tax Withholding

  • Some states require income tax withholding, similar to the federal requirements. You’ll need to have employees complete a state-specific version of the W-4 form.

State Unemployment Insurance (SUI)

  • Employers are generally required to contribute to their state’s unemployment insurance fund. The rate and payment thresholds differ by state, so make sure to check with your state’s labor department.

Workers’ Compensation

  • Many states mandate workers’ compensation coverage for employees. This insurance protects workers who are injured on the job. You’ll need to enroll in a workers’ compensation policy once contractors become employees, even if they are still performing the same tasks.

State-Specific Employment Laws

  • States like California have stricter classification guidelines (e.g., California’s ABC test under AB5). You should be aware of specific worker protections, overtime rules, meal breaks, paid leave, and other benefits as these vary greatly by state.

4. Benefits and Wage Requirements

Once workers become employees, you may need to offer them benefits and adhere to wage requirements:

  • Minimum Wage and Overtime: You’ll need to pay your employees at least the minimum wage set by federal or state law, whichever is higher, and pay overtime for hours worked over 40 in a week unless they’re exempt.
  • Health Insurance (ACA Compliance): If your company employs 50 or more full-time workers, including new W-2 employees, you must provide health insurance or face penalties under the Affordable Care Act (ACA).
  • Paid Time Off (PTO) and Sick Leave: Many states and municipalities have laws requiring employers to provide paid sick leave. Additionally, offering vacation and PTO to full-time employees can be part of an employment package.

5. Documenting the Transition

During this transition, clear documentation is crucial:

  • Amend Contracts: Ensure that any independent contractor agreements are ended, and new employment contracts are established with updated terms, including pay, benefits, and responsibilities.
  • Notify the Workers: Inform contractors of their reclassification and what it entails — new tax withholding, benefits, and changes in work expectations.
  • Set Up Payroll: Ensure payroll systems are updated to handle income tax withholding, Social Security, and Medicare contributions. You’ll need to issue W-2 forms at year-end instead of 1099s.

6. Employee Training and Onboarding

Once you’ve handled the legal and tax side, it’s time to integrate your new employees into the company’s culture. Provide them with clear onboarding, including training on workplace policies, benefits, and expectations for behavior as a W-2 employee.

Suggestions for a turn-key approach that ensures everyone is fully satisfied with this new company culture:

  1. Reboard your contractors. This includes having a new offer letter. This is the first step to sharing the vision of their new position. 
  2. Plan a team luncheon and create a new hire basket or fun bag with new swag, logoed apparel and a handwritten card or note as to why you, the business owner, look forward to them being on the team. Handwritten notes go very far in this journey. It shows that you are sending them a heart-felt message of their importance to your organization. 
  3. Host the luncheon and/or meeting and complete the necessary W2 documentation together as a team. Make it fun and exciting. This might cost you an hour or two worth of wages, but it will allow you to complete all the necessary steps in the hiring process at the same time. It will also come back to you two-fold by making the investment.
    1. Hold orientation. As with any new hire, orientation with the new standards is just as important for a transition as it is to the newcomer. Even if a contractor has been with you for a length of time, it is important for you to state the facts: “My expectations are …” (they have never had expectations because they were not fully invested in your business previously.)
    2. Present them with the employee handbook and go through the crucial parts of the organization.
    3. Provide all the necessary state and federal mandated training and have them sign off on all the mandated policies.
    4. Welcome them to the team!

This may sound a bit “much,” but keep in mind that a new hire or transitioned employee will have expectations and questions. This is a great time to walk through questions they might have. I guarantee that if they’re asking, there are others thinking the same. You are starting everyone out on the same path at the same time. 

Last but not least, white board all questions. Document the discussions you may have that are side-lined. Be upfront if you don’t have the answer at the time of the question. It is perfectly fine to let them know you will get back with them … and don’t forget to get back to them. Showing a simple response ensures they can build trust in you as their leader, and it shows you care about them. These are key drivers to ensure a great transition is all about trust. Like the old saying says, “Say what you mean, and mean what you say.”

Don’t forget to recognize their performance after kickoff. Recognition goes a long way. It is one of the No. 1 reasons employees leave an organization. I bet you were thinking it was pay. No! It is recognition. Saying “thank you” or “great job” or providing them with guidance to becoming a better employee is far more desired than their paycheck.

At Extraordinary Workforce, you will find reassurance that this process will run as smoothly as possible. We will work with you to determine which state and federal mandates are required for your industry as far as documentation and human resource training. Don’t get caught trying to do this on your own if you are unfamiliar with the process. The cost can be significant if you don’t complete this correctly. 

Extraordinary Workforce

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At Extraordinary Workforce, we’re committed to helping your business succeed. Whether you need guidance on HR strategy, leadership development, or workforce optimization, we’re here to provide tailored solutions that fit your needs. Reach out to us today, and let’s start the conversation.

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