“Why did my employer give me a 1099?” That’s a fairly common question heard around this time of year as people who are used to getting W-2’s from their employer actually receive a Form 1099-MISC instead. Well, as I’m about to explain, the difference is much more than just some minor paperwork.
First, some background. It can be tempting for new businesses to simply want to hire “contractors” instead of “employees” to save all the complexities that come with employees. So, rather than hiring a payroll service and dealing with tax withholding and insurance and a lot of other really fun tasks (well, ok, “complexities”) that go with hiring employees, a company will just call their employees “contractors” and give them a simple Form 1099-MISC at the end of the year. But in the eyes of the IRS (and state tax authorities), it’s not simply a matter of the business choosing a label that’s convenient and issuing the corresponding form. And there’s serious penalties for employers who are considered to have deliberately misclassified employees.
On the other end of the equation, it’s important for employees to know their status and the advantages/disadvantages of each. On numerous occasions, I’ve seen the rather unscrupulous tactic of employers announcing to their employees that they are now independent contractors and selling it as though it’s a clear benefit to the employees. This is usually not the case.
As an employee, it may be tempting to just take cash payments with no taxes taken out. But what the employer doesn’t take out for you, you’ll simply wind up paying later, plus additional taxes. And YES, you do have to report and pay taxes on all of your income, even if you’re paid in cash.
Here’s the downsides to being an independent contractor:
1) You’re subject to Self-employment tax. This tax, generally about 15%, is assessed on your earnings in place of the Social Security and Medicare taxes that normally come out of paychecks. As a self-employed person, this will be twice as high as what’s withheld from your paycheck because your employer is required to pay half the amount. When you’re self-employed, you pay both halves. So all things being equal, being an independent contractor will result in you paying more taxes overall, not less.
2) You’re not covered by unemployment insurance. As an independent contractor, it’s not only easier for your employer to let you go, but you also can’t use your earning from self-employment to qualify for unemployment benefits.
3) You’re not covered by workman’s compensation. If you get injured while working as an independent contractor, don’t expect to have your medical bills covered or receive any payments while you’re unable to work. Unless you pay insurance to provide this for yourself, you’re just out of luck if you get hurt on the job.
Of course, there are a few advantages to being an independent contractor. From a tax perspective, the one clear advantage is the fact you can deduct expenses directly against your income. As an employee, deducting work-related expenses is complicated, only available to people who itemize their deductions, and you’re generally not able to get the full value of expenses as a deduction. But as an independent contractor, you simply subtract all job-related expenses directly from income. And these expenses even reduce your self-employment tax; unlike as an employee where work-related expenses never reduce your Social Security/Medicare taxes. As an independent contractor, you’re also usually eligible to deduct the premiums you pay for health insurance, while employees who have to obtain their own insurance generally aren’t able to do this.
The take-away from all this should be: whether you’re an employee or employer, be careful about the “independent contractor” classification when workers might really be employees. When in doubt, talk to a competent accountant, lawyer, or the IRS. And as an employee, be aware that being paid in cash as a “contractor” is usually not all it’s cracked up to be.
Here’s some additional info from the IRS…
As a small business owner you may hire people as independent contractors or as employees. There are rules that will help you determine how to classify the people you hire. This will affect how much you pay in taxes, whether you need to withhold from your workers paychecks and what tax documents you need to file.
Here are seven things every business owner should know about hiring people as independent contractors versus hiring them as employees.
1. The IRS uses three characteristics to determine the relationship between businesses and workers:
- Behavioral Control covers facts that show whether the business has a right to direct or control how the work is done through instructions, training or other means.
- Financial Control covers facts that show whether the business has a right to direct or control the financial and business aspects of the worker’s job.
- Type of Relationship factor relates to how the workers and the business owner perceive their relationship.
2. If you have the right to control or direct not only what is to be done, but also how it is to be done, then your workers are most likely employees.
3. If you can direct or control only the result of the work done — and not the means and methods of accomplishing the result — then your workers are probably independent contractors.
4. Employers who misclassify workers as independent contractors can end up with substantial tax bills. Additionally, they can face penalties for failing to pay employment taxes and for failing to file required tax forms.
5. Workers can avoid higher tax bills and lost benefits if they know their proper status.
6. Both employers and workers can ask the IRS to make a determination on whether a specific individual is an independent contractor or an employee by filing a Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, with the IRS.
7. You can learn more about the critical determination of a worker’s status as an Independent Contractor or Employee at IRS.gov by selecting the Small Business link. Additional resources include IRS Publication 15-A, Employer’s Supplemental Tax Guide, Publication 1779, Independent Contractor or Employee, and Publication 1976, Do You Qualify for Relief under Section 530? These publications and Form SS-8 are available on the IRS website or by calling the IRS at 800-829-3676 (800-TAX-FORM).
- Publication 15-A, Employer’s Supplemental Tax Guide (PDF)
- Publication 1779, Independent Contractor or Employee (PDF)
- Publication 1976, Do You Qualify for Relief under Section 530? (PDF)
- Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding (PDF)