Independent contractors can be a cost-effective solution for small business owners, but it’s important to understand the tax implications. Hiring employees directly may provide tax benefits that offset some of the hiring and training costs, so this article will examine both options and what your tax and accounting obligations are. Here are the key takeaways:
- Independent contractors must meet defined Internal Revenue Service (IRS) criteria to separate them from regular employees. That includes behavioral and financial control.
- The most important difference between W-2 employees and 1099 contractors is how they pay taxes and deduct business expenses.
- Businesses using independent contractors should request a W-9 Form with the payee’s tax identification number and report their income on Form 1099-NEC.
Let’s get started.
Who qualifies as an independent contractor?
A tax attorney once told me, “If it looks and walks like a duck, the IRS will categorize it as a duck.” Independent contractors must meet certain criteria to separate them from your regular employees. The IRS breaks this down into three categories.
- Behavioral control: Employees work mandated hours, receive detailed instructions or training, and operate under the direction of a supervisor. Independent contractors aren’t required to do any of that. That should be made clear in their contractor agreement.
- Financial control: Independent contractors typically take itemized business deductions when filing taxes, including the costs of equipment, supplies, and travel expenses. If the company pays those expenses, they’re likely an employee.
- Relationship type: Companies should require a signed agreement from independent contractors that defines the business relationship. Contractors do not receive employee benefits, and their work should not be identical to that of employees.
IRS auditors will closely examine the business relationship when evaluating independent contractor agreements. Follow these three guidelines and ensure the contract outlines roles and responsibilities. Please contact our office if you need assistance defining these roles.
What’s the difference between W-2 employees and 1099 contractors?
The most important difference between W-2 employees and 1099 contractors is how they pay taxes. This is where your company could incur penalties if you do it wrong. The best way to avoid that is to have the proper paperwork signed and the contract terms agreed upon before the contractor begins any work for the company. Read the next two sections carefully.
Hiring a W-2 employee carries a larger tax and administrative burden.
An individual who receives an hourly wage or salary is an employee, not an independent contractor. That means the employer must withhold 7.65% of their income and pay quarterly tax deposits to the IRS. We’ll get into that in more detail below. For W-2 employees, employers must
- Withhold income taxes;
- Withhold and pay Social Security and Medicare taxes;
- Pay unemployment taxes;
- Provide benefits (in many cases);
- Reimburse expenses; and
- Follow labor laws regarding minimum wage and overtime, among other responsibilities.
Working with 1099 has advantages, but there are a few guidelines to know.
An independent contractor gets paid a straight fee with no payroll deductions. Since the employer is not making tax deposits on their behalf, a contractor is assessed a self-employment tax of 15.3%. To offset some of that, independent contractors can take itemized business deductions. Businesses hiring 1099 independent contractors
- Do not withhold taxes;
- Do not pay Social Security or Medicare taxes;
- Do not pay unemployment taxes;
- Are not required to provide benefits; and
- Are not typically responsible for reimbursing expenses.
There are two essential tax forms for contractors.
That same tax attorney I referenced earlier also told me, “Dot all your I’s and cross all your T’s.” The IRS loves paperwork. If you have it, an audit will go smoothly. If you don’t, get your checkbook out. To avoid that, ensure your independent contractor paperwork includes the following documents:
- Form W-9: A Form W-9 is a request for a taxpayer identification number, which can be either an Employer Identification Number (EIN) or a Social Security number. No business should issue a payment to an independent contractor without this document, and many companies also request legal identification to confirm the legitimacy of the payee.
- Form 1099-NEC: Fees of over $600 paid to independent contractors must be reported using Form 1099-NEC (non-employee compensation). The penalties for incorrect or late filing typically range between $50 and $280 per form. Intentionally failing to file could cost your company significantly more.
Avoid IRS misclassification penalties.
Knowing the rules is the first step. Complying with them needs to be embedded in your systems and processes. That should start from the beginning of the recruiting phase and continue through the life of the independent contractor agreement. Use the IRS guidelines above to define terms and conditions. This can help you avoid the following penalties:
- Back payment of employment taxes owed
- Penalties of up to 100% of unpaid taxes
- Interest accrued from the back tax due date
- Owner’s personal and legal liability
One way to avoid these penalties is to ask for a W-9 and confirm the identity of the party you’re doing business with. If you’re still unsure, you can use Form SS-8, Determination of Worker Status, to further protect yourself. Keep all relevant documents, including the independent contractor agreement, in a location where they can be easily accessed. Follow these guidelines, and you can avoid the negative tax implications of working with independent contractors.
Make informed hiring decisions and stay compliant with regulations.
The cost for retaining our services will be significantly less than what you’d pay for making mistakes on independent contractor classifications or quarterly tax deposits. Your tax needs and obligations will grow and evolve as your business expands. Consider us an executive-level partner in that journey.
To get started, schedule a discovery call.
Talk soon,
Jeremy A. Johnson, CPA