1099 VS W2 Taxes

For many of us the difference between 1099 Independent Contractors and W-2 Employees is very clear for various reasons. But there are many out there that either never encountered it or never thought to discover their differences. In this article, I will try to provide you with the necessary information so that you can determine which situation is better for you.

W2 #

We will start off with W2 because it's more common, chances are that most if not all the jobs you've had in the past used W2. When a person is paid on the form W-2, the employer automatically withholds and pays all of the necessary employee income taxes as required by the IRS. These taxes include: Federal Income Tax, State Income Tax, and FICA (Social Security and Medicare). In addition, the employer will pay all of the necessary employer taxes. These taxes include: FICA (Social Security and Medicare), FUTA (Federal Unemployment Tax), and SUI (State Unemployment Tax). In most cases, the employer provides the equipment and office space you need. You may be eligible for some or all of the benefits your employer offers to permanent employees such as medical, life, and disability insurance; pension plans; sick days; paid holidays, etc.

1099 #

Working on a 1099 basis means that you are working as a true independent contractor under the IRS rules. You work on a 1099 basis when you are in business for yourself as a sole proprietor or as a corporation. Your clients report the money they pay you to the IRS on a 1099 form. Your clients typically contract with you to work on a specific project. You should have a written contract with each client that delineates the work you will perform, the fees the client will pay, and how the client will pay you. You will send invoices to the client in accordance with the contract terms. True independent contractors are responsible for tracking all business expenses and income and for making quarterly federal and state income tax payments.

The IRS and Taxes #

In recent years, the IRS has begun to realize the large sums of potential tax revenue they are losing due to misclassified 1099 independent contractors who should legally be W-2 employees. When a company pays a contractor on a 1099-misc form, they avoid the following: federal and state tax withholdings, deposits and reports, the employer's share of Social Security and Medicare taxes, state and federal unemployment insurance premiums, state disability insurance premiums, Workers' Compensation costs, fringe benefits, vicarious liability for employee negligence, and EEOC regulations. The IRS estimates that it loses between $4 to $20 billion per year in unpaid taxes as a result of this misclassification problem. Understandably, the IRS has made it a priority to investigate 1099-misc forms that are turned in at the end of the tax year. The IRS is continually conducting audits to determine whether or not contractors are being properly classified. Needless to say, there are many 'companies' out there more than willing to exploit the freedoms of 1099 so careful consideration is necessary to ensure you are not falling into that misclassified 1099 independent contractor position. I've done some research and found some great resources that spell out the telltale signs of what should be an employer-employee relationship.

The IRS Control Test #

Common law defines an employer-employee relationship as one in which the employer has the right to control the "means and details" by which services are performed. Years ago, the IRS developed what came to be known as the 20-Factor Test, an analytical tool for distinguishing employees from independent contractors. This evaluation method was revised in 1996. The current test evaluates the degree of control according to three criteria: behavioral control, financial control, and the relationship between the parties. BEHAVIORAL CONTROL Instructions. If a company gives a worker instructions pertaining to how the work gets done rather than simply to the end product, this is evidence of an employer-employee relationship. The more detailed the instructions, the stronger the evidence. Examples of instructions indicating that a company controls the means and details of the work include:

  • When and where to work
  • Which assistants to hire
  • Sequence of steps to follow

Training #

Ongoing training about specific methods and procedures is evidence of an employer-employee relationship. Some kinds of training, however, are consistent with independent contractor status. These include informational sessions about new policies or pertinent government regulations, and voluntary training programs for which workers do not receive compensation. FINANCIAL CONTROL Opportunity for profit or loss. The IRS considers the opportunity for profit or loss to be the most significant test of whether a worker maintains control over the economic aspects of his or her activities. An independent contractor has the freedom to make business decisions that impact the profitability of his or her enterprise. Such decisions might be related to the types of equipment to buy, or how to invest capital. In addition, the following factors contribute to the worker's opportunity for profit or loss:

  • Significant investment. A significant financial investment on the part of a worker, such as the lease of office space, or the purchase of equipment, is evidence that the worker is operating as an independent contractor. Since some types of work do not entail large expenditures, an absence of a significant investment is not necessarily a sign that the worker is an employee.
  • Unreimbursed expenses. While companies usually reimburse employees for their incurred business expenses, some also reimburse independent contractors. Consequently, the IRS does not consider reimbursed expenses to be an important factor in distinguishing the two groups. The presence of unreimbursed expenses, on the other hand, is taken to be evidence that the worker is an independent.
  • Services available to the relevant market. If a worker makes his or her services available to other potential clients, this is evidence of independent contractor status. However, a contractor may hold only one contract for a period of time without it constituting an employment relationship, as long as his or her services are available to other companies.

Relationship of the Parties #

Intent of the Parties/Written contracts #

In determining the relationship between a worker and a company, the IRS considers how the written contract describes the intent of the parties involved. What is important is not the title specified in the contract (contractor or employee), but any evidence of which party maintains control (descriptions of the rights and obligations of the parties, reimbursement of expenses, etc.). Although intent is not considered substantial evidence in itself, it can play a pivotal role in cases where other evidence is ambiguous.

Benefits #

If a company grants a worker employee benefits, such as health insurance or paid vacation time, this is evidence of employee status. However, the absence of employee benefits is not necessarily a sign of contractor status, especially in cases where the law does not require a company to offer benefits.

Termination #

Traditionally, the terms on which either party could terminate the relationship played an important role in determining whether a worker was an independent contractor or an employee. The ability of either party to terminate at will was taken as a sign of an employment relationship. Because of the complexities of labor law and modern business practices, however, the IRS now gives less weight to this type of evidence.

Ongoing Relationship #

If a business and a worker enter into a relationship with the understanding that it will be permanent or indefinite, this is evidence of an employment relationship. However, long-term contracts, as well as contracts that are regularly renewed because of excellent service or competitive prices, are consistent with independent contractor status.

Regular Business Activity #

If a worker performs activities or services that are "a key aspect of the regular business of the company," this is evidence of an employment relationship. This does not mean that a contractor cannot perform important, necessary work for a company. It simply indicates that the work cannot constitute one of the company's essential functions. For example, a frozen yogurt shop may hire a contractor to install and repair the yogurt machines. Although this work is essential, it is not part of the company's regular business.

Please note that this information is provided only as guideline. According to the IRS's own publications, there is no "magic number" of criteria that determines whether a worker is a contractor or an employee. In each case, the evidence should be weighed to see which party maintains the predominant control over the means and details of the work. For more information, visit the IRS Web site at www.irs.gov. Excerpts of this article were obtained at eWork Services.