1099 Contractors vs. W-2 Employees

Tips to Avoid Problems and Penalties

Reasons to Hire a 1099 Contractor
You may decide to hire a 1099 Contractor for many reasons:

  • These contractors give your company flexibility. You may temporarily need individuals with a certain expertise or skill that your employees lack.
  • You want to avoid paying unnecessary taxes. Companies do not need to pay payroll taxes for independent contractors.
  • You can reduce legal exposure. Many state and federal laws offer certain rights to employees (overtime pay for example). Since these contractors are independent (and treated as a business), they are not covered by many of these laws.

If it walks like a duck…

If it walks like a duck... it's a duck.

If it walks like a duck… it’s a duck.

Just be careful. You should only classify individuals as independent contractors if your relationship with them meets the classification criteria defined by the IRS.

If the individual does not meet these criteria, the IRS could classify them as employees and you can face problems, including penalties and fines.

As the saying goes if it walks like a duck and talks like a duck, it’s a duck.

IRS Criteria for Independent Contractor Status

The IRS stipulates individuals must meet these criteria to be eligible for the independent contractor status.

  1. Limited behavioral control – this requirement means that you do not exert control over how the individual does his or her work (for example: you do not provide training or supervision or you do not specifically tell the individual how to do the job)
  2. Limited financial control – you do not purchase equipment or materials for the individual.
  3. Temporary business relationship — both you and the individual agree that the relationship is temporary. The individual does not have a permanent place in your business. The individual is not an integral part of your business. They may also offer their service to other companies.

Penalties for Improperly Classifying an Employee as an Independent Contractor

If you misclassify an employee as an independent contractor you can rack-up substantial tax bills. The IRS can fine employers who willfully violate the classification criteria $5,000 to $15,000 per violation.

Additionally, you can face penalties for failing to pay employment taxes and for failing to file required tax forms.

This is not the time to risk this violation. The U.S. Labor Department has allocated $14 million in its 2014 budget to investigate 1099 violations.

Even large companies must adhere to this law. In a landmark case a few years ago, Microsoft had to pay more than $97 million dollars in fines to the IRS and back pay and stock options to employees improperly classified as independent contractors.

Penalties for Not Filing Required 1099 Forms

If you hire a 1099 contractor and pay the individual more than $600 in a calendar year, you must send a 1099 form to the contractor by January 31. You must also use form 1096 to transmit 1099-misc forms to the IRS by February 28.

If you fail to properly report these 1099 payments (of $600+), the IRS can fine your company from $30 to $100 per form (up to a maximum of $500,000/ per year), based on how long past the deadline the company files the form.

Avoid Any Penalties Related to 1099 Contractors

To avoid potential penalties and issues related to 1099 contractors, use these guidelines:

  1. Make sure your relationship with these contractors meets the IRS criteria.
  2. Develop a written contract with the independent contractor that spells out the relationship
  3. Ask the 1099 contractor to complete a w-9 form
  4. File a 1099-misc form at the end of the year for each independent contractor to whom you paid more than $600 in the calendar year. Submit those forms to the IRS by the February 28 deadline.

Final Tips for 1099s:

If you decide to move an individual from a 1099 status to an employee status, do so at the beginning of the year. You should not issue a 1099-misc form and a w-2 to the same individual in one year.

You should never move an individual from a 1099 status except under special circumstances. This can be very difficult to substantiate.

Feel free to contact us if you have any questions concerning this information. We are happy to speak with you.

Posted in General Tax Tips & News

Posts per Category

Business Startup Accounting Tips

General Tax Tips & News

QuickBooks tips

Small Business Accounting Tips

Contact Us