W2 or 1099...The Question That Haunts Business Owners

One of the first thing that is looked at in state or federal audits is 1099's that you sent out to subcontractors. Here are the rules about W-2 employees vs 1099 contractors. This episode will keep you out of possible trouble with the state or the IRS if looked at by them. 

Transcript

                                                        Episode 5

Welcome to this episode of the (Not Boring) Boring Small Business Bookkeeping and Accounting Podcast 

Today, I want to spend some time on a subject that comes up all year, especially during tax season. That subject is: 

1099 Subcontractors VS W2 employee Status 

In the 1950’s and 1960’s, most people worked for Corporations and other types of businesses and got paid every week or every two weeks like clockwork.  A 35-40 work week was pretty standard along with possible overtime.  If you worked for a company for 25 years, you would get a present or a plaque.  Or when you became 65, you’d get a retirement party and a gold watch for your years of service.  The standard was having an office to go to every day, a desk (or an office) that was assigned to you alone, and a schedule that was the same routine every day. 9-5.  There was even a movie about that with Dolly Parton and Lilly Tomlin called 9-5. 

What you got as a W-2 employee was a guaranteed paycheck every pay period, vacation days every year that would increase with the more time you were employed at the company, life insurance, 401K benefits, sick days and have the company who pays you do the administrative work so that your taxes would be deducted from your paycheck before you get your ‘take home’ pay or your ‘Net Payroll’.  You also got protection from the state labor commission to protect you from being fired for no cause. 

The company who you worked for got an employee working the schedule that the company wanted you to work, a desk or an office where the company wanted to place you, and to have people conform to ‘their way of doing things’ 40 hours a week, 52 weeks a year, mandatory company picnics, and Holiday parties.  

This was the standard since way before I was born. And many people, even after Covid, are still working as a W-2 employee for a small or large company.  

My father was a business owner in the 1950’s through the 1990’s, when very few people owned their own businesses.  Being a business owner doesn’t guarantee you a weekly or a monthly paycheck, and figuring out taxes as a self-employed individual is very different than being an employee of a large company. 

More and more people have been leaving the W-2 world and starting their own businesses in the last 20 or 30 years. 

When you become self-employed and own your own business and get to the point that you want to hire your own people, it’s not as easy as it sounds. 

Do you hire a W-2 employee or do you hire an independent contractor who you pay an hourly or a daily rate rather than handle their IRS and state taxes through a traditional paycheck?  

Well, I have bad news for business owners.  It’s not your choice on the status of who you hire. There are specific rules that governs W-2 employees vs the 1099 Independent Subcontracted Services people. 

We have talked about W-2 employees --  that is ---  the company deducts an employees payroll taxes from their paycheck before the employee gets their ‘take home pay’, and the company pays ‘their share’ of IRS and state payroll taxes for the right to hire an employee and have that individual under their control 35-40 hours a week or more if they are salaried or working overtime.

But subcontractors are different. Any kind of subcontractor should be some kind of a registered ‘business’.  Even an individual – and we’ve talked about this in an earlier episode of this Podcast --  a Sole Proprietorship is a registered business entity for an individual independent ‘freelance’ worker. So, if you are an individual who has a specific skillset and you perform your labor for any company or companies who would hire you, then you would be classified as a ‘Subcontractor’.  A Subcontractor doesn’t have a ‘paycheck’ per se – no taxes deducted for the subcontractors’ earnings --- the subcontractor charges an hourly or a daily fee.  For an example, if the daily fee is $300.00, then at the end of the day, you would get paid $300.00 which is counted as taxable income by the IRS.  However, since the individual is a subcontractor, and a ‘business’, there will be tax deductible expenses that you can then take off your taxable income by deducting expenses that the IRS allows you to deduct—and that’s another upcoming episode of this series.  So, the $300 income that you earned for the day, might be $200 of taxable income if you have legitimately  $100 of business deductible expenses that the IRS allows you to take.  

Just because you think it’s a better’ deal’ to be a subcontractor, or the company who hires you doesn’t want to pay their share of the IRS and state taxes on your behalf, it doesn’t mean that you can be classified as a ‘subcontractor’. 

The full term ‘Independent Subcontractor or Subcontracted Services’ means just that.  Independent. 

In other words, unlike a W-2 employee who is given a schedule by the employer, and an office or a desk, lunch hour, overtime pay, maybe a dress code, etc., an independent contractor is his/her own company.  The best example that I can give is a plumber. If you have a leak and you need a plumber, when you contact a plumbing company, you don’t tell them – 

1. When you want them to show up.

2. What they should wear

3. How much you are going to pay them or

4. When they can take lunch

In reality, the plumber will tell YOU when they can get there, what they will be charging you, and when they are going to take a break for lunch or go out and get parts if needed. 

When hiring a subcontractor, you are hiring an individual or a company who might subcontract an individual to perform the service for you. They will not need supervision--- they know how to do what they do and they will either bill you or give you a receipt for your payment right at the time of the service if requested. 

So, if you are a business owner, and you want to hire someone to perform a service, you have to conform to a check list on hiring to determine if the person who you are hiring should be paid as a W-2 employee or a 1099 subcontractor. 

If you, as a business owner, needs to hire a worker and you both agree that the worker is on a schedule, and you give them a workplace (desk, chair, computer, Etc.), then that person should be a W-2 employee. When I used to travel around to different clients’ offices to do bookkeeping, I was always very careful---- I would bring my own laptop that I can use.  I would sit in a back room somewhere, and not at an employee desk or workstation, since I was not an employee of my clients company.

When I do bookkeeping from my office, no-one is there to supervise me. People can request that I get their books done early in the month, but there’s nothing forcing me to do that.  However, as an independent subcontractor, I have no ‘job security’, and if I don’t get books to a client early enough in the month, they can always say----   “I want my books by the 10th of every month, and I need to move to another bookkeeper because I’m getting my books on the 20th of the month”.  And that could be the last month that I’ll be their bookkeeper. That never happens, but it could. I have my own office, my own equipment, my own schedule, and I am being relied on to do bookkeeping in an accurate way because I am hired as a expert subcontractor. No supervision is necessary. If people don’t like the service that I’m providing, they don’t have to use me. They can move to another bookkeeper or bookkeeping service without notice.

Supervision is a big item in the IRS checklist.  If you hire a subcontractor for an event company, for one example, and you have any kind of a sign in sheet or time clock or phone app to let you know when the subcontractor shows up, that, right there, could classify your subcontractors as W-2 employees. The state labor board can give you a tremendous fight if they find out because it’s considered supervision. And once the state gets involved, the IRS will follow, since they work together on these matters.  

The 1099 NEC (Non- employee compensation) is the most common 1099 form that is created and filed with the IRS and sent to the recipient on Jan. 31st of every year for the previous year.  

If you pay someone using Zelle, Venmo, CASH (yes, cash), Debit card, check or wire transfer, YOUR company is responsible to provide a 1099 to them. The $600 threshold means that once you pay that person or company $600 a 1099 in Jan. of the next year is in their and your future.  

However, one of the exceptions is if you pay a lawyer, even $200.00 (under the $600.00 threshold), they still get a 1099 form. The other exception is if you pay using a credit card (Debit cards don’t count), the credit card company will provide a 1099K to them automatically.  So, if you can pay a subcontractor with a credit card, it’s less work and less headaches for you and your bookkeeper in January of every year. 

How do you get the information from the subcontracted company or individual so you have information to create a 1099 you ask?   THAT form is called a W9.  It’s available on www.irs.gov for easy download.  You can email the form to every person or company that you pay who is eligible for a 1099.  Corporations are NOT eligible, but most of the time, you might not know if you are paying a corporation or LLC without getting that W9 form. The W9 form is an information form for you --  it doesn’t get mailed to the IRS or to your state. You need to keep them for any potential state audits.

More about 1099 MISC in another episode. 

And here is a General Client story --- 

I had started many years ago with a new client, and that client had been taking care of their own 1099’s. Their bookkeeper was taking care of the books, but the company kept a spreadsheet of payments to individuals who would be eligible for 1099’s. Some W9 form were gotten, others were name, address, Social Security or Tax ID number written in email – enough information to put on a 1099 form, and they sent a list to their accountant, and their CPA did all the 1099’s.  The first year I took the books over, part of what I do is create 1099’s in Jan. of every year.  I asked for the W9 or the information on all subcontractors on their list, and they sent them to me, but had also sent their list to the CPA in the middle of December.  By the beginning of Jan., the CPA had already created the 1099’s. I compiled the list through December 31, and found 10 or 12 more companies who were eligible for 1099’s.  I sent the list to the client, and our numbers were off by around $40K. The CPA had to amend all of the 1099’s that he filed, and he worked from my list.  There are nuances in filing a 1099 form, (reimbursements for one) and trained bookkeepers know how to accurately put together 1099’s.  As a business owner, all you have to do is to get a filled out W9 form BEFORE you pay anyone and forward those to your bookkeeper.   

Even though January is the most stressful time of the year for me personally because of the 1099’s, it always makes me feel good that 140 sets of these forms were filed, and filed accurately and properly by Jan. 31st.  Even if you don’t make the deadline, the IRS accepts these forms through March electronically.  There are many websites that allow you to file electronically (for a fee of course) with the state and with the IRS.  There are fines and penalties for not doing this correctly, so this is one of the rules that you really have to follow carefully if you don’t want to be bothered by the state or the IRS at a later date.  

I’m Paul Rosenblum, and thanks for listening and stay tuned for the next episode of the (Not Boring) boring Podcast Small Business Bookkeeping and Accounting Podcast!