As business owners, understanding the difference between W2’s, 1099’s, employees and contractors is critical. Failure to do so can result in costly mistakes.
Unfortunately, misclassifying workers is common, especially in the land of small business.
what is a w2?
A W2 is a tax form that must be filed for any employee that you have paid a minimum of $600 to over the course of a year. You must file a W2 for every employee you have.
The W2 has a partner form called the W4, which is a form that all new employees must fill out before beginning their first day of work. This form tells the employers things like whether or not to withhold income tax, or whether or not an employee wants extra taxes withheld. The W4 does not have to be filed, but as a general rule of thumb, you should keep all payroll records for a minimum of five years.
(Payroll is complicated – even for accounting and bookkeeping professionals. A pro tip? Consider working with a payroll provider – Good Cent’s absolute favorite is Gusto. They handle all the payroll things like filing tax forms, remitting taxes on your behalf, direct deposits, etc.)
WHAT IS A 1099?
A 1099 form, aka a 1099 NEC form, is a form that must be filed every year if you have paid a subcontractor $600 or more during the calendar year.
You must also file 1099 forms for lawyers and accountants, as long as they aren’t incorporated. Don’t let them tell you otherwise.
Similarly, the 1099 has a partner form called a W9, which you should be sure to have your subcontractors fill out PRIOR to starting work with you (or as soon as possible).
It’s best practice to collect this form before you pay the contractor – you’ll need it to file that 1099 NEC.
If you try to collect the W9 down the line after you have paid the person, don’t be surprised if your requests go ignored – we see it happen all.the.time.
So… what’s the difference between employees and contractors??
There is widespread confusion about the legal difference between employees and subcontractors (or freelancers) – I hear this often from my bookkeeping clients.
The truth is, the IRS has outlined very specific laws about who qualifies as what. And making an incorrect decision on how to classify your workers can sink your business if you get caught. Likewise, there are also very specific state laws – so you need to pay attention to the laws both at a state and a federal level.
There has been a huge shift in corporate and business culture over the last decade, which assumes that if someone works for you on a part-time basis, they’re automatically a freelancer.
This is incorrect. (And in fact, years ago, the opposite was assumed true: If someone worked for you part-time or full time, they were automatically an employee.)
The IRS has a well-designed guide to help you determine the nature of your relationship (and therefore which tax form to issue them), but let’s dive in a little below.
What defines an employee?
If the person comes to your place of business, you expect them to show up at certain times and maintain a regular schedule, they use some or all of your equipment and they work primarily for you, they are an employee. Sometimes this is referred to as an “Elements of Control” test.
What defines a contractor?
If a person controls their own schedule, works on their own equipment, maintains a roster of other clients, and you have written contracts in place detailing your working arrangement, then they are most likely a subcontractor.
Side note: In the age of the increasing “digital workforce” and the “gig economy,” things can get a little murky. If you’re unsure how to classify someone, check with your accountant or lawyer!
So, what’s the confusion?
The rules seem pretty clear cut, right? So how does misclassification tend to happen? Aside from ignorance, the answer is singular: cost.
Employees mean more money out-of-pocket for the business.
Even without offering health insurance or retirement benefits, employees cost more money to pay.
This is because, in addition to an hourly or salary rate, the business must also contribute to their employees’ social security (an additional 6.2%) and Medicare accounts (an additional 1.45%), pay into federal unemployment, pay into state unemployment, and maintain and pay for disability and workers compensation insurance policies (insurance requirements vary by state).
On top of this, many times business owners need to invest in an outside service to handle payroll.
But misclassifying workers to save costs can backfire – big time.
Once upon a time, I had a client who was audited by the U.S. Department of Labor. The DOL was trying to determine if he had chosen the right classifications regarding his labor force.
My client had classified them as temporary or freelance workers (aka contractors)… unfortunately, the department of labor did not agree.
The result? Almost $10,000 in back taxes, penalties, and necessary accounting costs to help sort the whole mess out. It was one of the costliest mistakes he had ever made in business.
And he regretted it.
The lesson? Be honest when classifying your workers.
Don’t try to cut corners to save money when deciding on employees or freelancers.
If you’re certain your relationship is a freelance arrangement, hire a lawyer to draw up an agreement spelling out the terms.
If your team member clearly meets the employee requirements outlined in the IRS guidelines, contact a qualified bookkeeper or accountant, and put them on payroll.
While, yes, employees cost more upfront, it’s so much better to be compliant and save yourself potential costly penalties down the road.
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