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  • Dwight Brisendine

1099 vs. Payroll Labor

When retaining someone to perform work for a business, a very important question for the owner is whether a person doing work is an independent contractor (“1099”) or a statutory employee (“W-2”). This can be a highly complex legal and tax matter. This article cannot outline all of the issues involved. It is, instead, offered as a brief outline of some of the relevant factors in determining which category a person doing work for a business falls into. Legal and tax advisors should be consulted for definitive answers.


Overview


A 1099 independent contractor is not considered to be an employee of the business that hires his or her services. A 1099 contractor is not subject to payroll tax withholdings and payroll taxes paid by the company. Such a person is not covered for “employee benefits”. An employee, on the other hand, is subject to tax withholdings (social security, medicare, federal and state income taxes) and to payroll taxes assessed on the employer (social security, medicare, and unemployment). Further, an employee has certain rights under rules of “employee benefits”. Annual compensation to a 1099 contractor is reported by a Form 1099-MISC; an employee’s compensation is reported on an annual Form W-2 and various other payroll tax filings during the year. If a person is paid the same gross rate as either a contractor or an employee, it is less expensive to the business to have the person classified as a contractor than an employee. The lower cost and fewer tax filings are primary reasons that many business owners prefer the 1099 classification. However, this classification can come with substantial risks if not properly evaluated and assigned.


Problem


The rules for 1099 vs. payroll labor are very complex and can be somewhat unclear and subject to varying interpretations. There is also a strong preference by tax and other related agencies to want payments to individuals for services classified as payroll, not as 1099 (more money for them). Also, there seems to be an increasing number of audits concerning this subject. Among the entities that look closely at labor classifications include the IRS (income taxes), the State (income taxes and unemployment taxes), insurance companies (liability and worker’s compensation insurance premiums), and Wage & Hour (underpayment of compensation). Should an audit determine that a business has improperly classified payments as 1099, the penalties can be quite substantial. As a result, this matter should be explored carefully before classifying someone as 1099.


Fundamental Rules


The basic rule is that a person doing work for a business is an employee if the business has “the right to control and direct the way the work is done, not only in terms of results, but with the details of when, where, and how the work is done.” This definition is not exactly clear cut and can lead to varying interpretations by different employers, agencies, and auditors. These are examples of just a few specific questions that can help determine which category is appropriate:

  • Who controls the hours, days, etc. that the work is done?

  • Does the worker provide his or her own equipment, materials, and tools?

  • Is the worker under the supervision of someone in the business?

  • Is the work temporary or permanent? Intermittent or ongoing?

  • Does the worker do the same work for other businesses?

  • Is the work always done on the premises of the business?

  • Does the worker submit written progress reports to the business?

  • Does the worker do the work under a social security number or a FEIN?

There are many other such questions that an auditing agency can ask, but these should provide the flavor of the issues to be explored.


Form 1099 Filing


If you have determined that a worker qualifies as an independent contractor, and you pay them $600 or more during a calendar year, you must prepare and file a Form 1099 by the end of January immediately following the end of the calendar year. A problem that many businesses have is failure to get the proper information when the worker is retained, and then being unable to obtain it after the work is complete. The information you should obtain up front is:

  • Worker’s name and mailing address

  • Worker’s tax identification number (either social security number or Federal Employer Identification Number)

It is advisable to set up the business’ bookkeeping to easily track 1099 payments during a year. This can save both time and money at the end of the year.


Summary


It can be quite tempting to classify someone doing work for a business as an independent contractor (1099) and not as an employee (W-2), as it can save significant expense to the business. This can, however, be a significant financial problem if the rules for classification are not met. It is in the best interest of the business to research this matter before deciding which is appropriate and be sure that the classification that is selected meets the proper criteria. The financial risk of misclassification could be substantial.

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