Over the past week or so, several new clients have come in. Each handed me ONE 1099-MISC. This form showed an amount in Box 7 (“Non-employee Compensation”), which indicates that they were treated as independent contractors and not employees. So before I went through my litany of questions such as what type of expenses they had, I confirmed with them that they only worked for this one company as they gave me just ONE 1099. It is apparent that the statement was true (unless that are hiding earnings and I do not want to know about that).
Anyway, after asking the pertinent questions, it became evident that they were really employees. This situation is not new and is usually the case when there is one or maybe two 1099s. So then I ask several questions like, can they hire themselves out to their competitors? Can they substitute someone else if they cannot work that day/week, etc.? Does their “employer” tell them where to go, when to go and give them the tools to do the job? Most of the time the answer to the first two is no and to the last is yes. There are other questions I ask, but you get the point. They may not be independent but are actually employees.
So what is the big deal? Well, the taxpayer will pay not only income tax on the amount on the 1099, but also the self-employment tax. That is an extra 15.3% tax. I have several clients that are genuinely independent contractors that owe this tax even if they owe no income tax; i.e., net profits are low enough to be offset; by their itemized or standard deductions and in the past, by their exemption deductions. Depending on the net profit, that could be a big hit.
Another question is why would their “employer” do this? Simply put, they do not have to pay their share of the taxpayer’s social security and Medicare (7.65% of the gross pay) or the federal unemployment tax ($42 per person) or the state “re-employment tax” (as much as $189 per person). If they do this as a matter of policy, the tax savings add up. Then they tell the “independent” to get their own liability insurance, and they do not have to provide benefits. It is strictly a matter of dollars and sense.
The law states that one can be an independent contractor if it is common in their industry. One such sector is realtor estate agents, though this is not absolute. Realtors are considered true independents by the industry because it is said that they work for the person selling or buying the real estate, not the broker or the company (i.e., Keyes, Keller Williams, etc.). However, if they perform work outside of the scheme of being a realtor (pictures, advertising), they should be W2’d on this income. Licensed mortgage brokers are another.
I teach other tax pros about when S-corp shareholders need to take reasonable compensation, and if you have heard my presentation on this subject, it is very often a problem. Anyway, a company whose blog on salaries and these items that I subscribe to came out with an excellent blog on 1099s versus W2s. In part:
Just to be sure we looked up the IRS definition of Employee and Independent Contractor, just to make sure there wasn’t some loophole or wiggle room to argue for independent contractor status.
Employee: Under common-law rules, anyone who performs services for you is your employee if you can control what will be done and how it will be done. This is so even when you give the employee freedom of action. What matters is that you have the right to control how the services are performed.
Independent Contractor: The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done.
What this means to your bottom line:
The IRS takes this issue very seriously and does not hesitate to assess hefty interest and penalties to folks who don’t comply. The IRS will reclassify all 1099-MISC payments made to S Corp owners as W-2 wages. This means that there are several months, sometimes even years of payroll taxes that the S Corp will now have to pay including the following:
- Back taxes for payroll taxes;
- Interest on payroll taxes;
- Penalties for failure to file quarterly Forms 941;
- Additional penalties for failure to timely pay the tax withholding to the IRS;
- Even more penalties for failure to file and issue Form(s) W-2;
- PLUS Back taxes for state and local payroll filings, interest, and penalties.
So in short, if you or anyone you know is in this situation, there are options, though you may not like it and goes beyond the scope of this email. If you are the employer and want to go this route to save money, call me first and let’s discuss. The IRS scrutinizes these things more than income taxes.
So until next time,
Jeffrey “providing the facts about 1099’s” Schneider