Is it OK to Pay Workers as 1099 Contractors?

Small business owners are always searching for ways to lower their taxes.

One of the most common tactics is to classify workers as 1099 contractors, rather than as W-2 employees. When done within IRS guidelines, classifying a worker as an independent contractor will save your business a significant amount of money in payroll taxes and employee-related benefits.

However, it pays to know the IRS rules that determine exactly when a worker can be paid on a 1099 basis.  When done without regard for the rules, paying workers as independent 1099 contractors can cross the line between legally avoiding taxes and illegally evading them.

If you’re an employer, the latter approach can be the single worst tax strategy on the planet.   

WHAT ARE THE RISKS?

Incorrectly classifying W-2 employees as 1099 contractors may result in significant IRS penalties, plus interest. These penalties and interest can place such a severe burden on the business that it finds it can no longer afford to operate.

Losing everything you’ve worked so hard to build over the years is too high of a price to pay.

WHAT ARE THE RULES?

The IRS lists many factors in determining whether your worker should be classified as a contractor or employee.  The hard part is there’s 20 different factors, and no single factor is the controlling factor.  We won’t list all of them here, but they generally fall into three main categories:

1.  Behavorial Control.  If you tell Paula, a painter, when to show up on the job, and how to do the job, and you provide the tools and materials she’ll use on the job, then this is a classic example of “behavorial control”.  You better be paying Paula as W-2 employee, and take out payroll taxes.

2.  Financial Control.  Does your worker have a significant financial investment in the work at hand?   Suppose Bart, a backhoe operator, does work for you, using a backhoe which he rents, but he pays a below market rate for the lease–which he can terminate anytime without penalty.  In addition, you pay for his liability insurance, plus you reimburse him for maintenance costs on the backhoe.   Here’s a case where it’s likely that the IRS would view Bart as a W-2 employee.   While it’s true Bart does have some skin in the game, it’s not likely the IRS would judge his financial interest to be significant enough to warrant paying him as a subcontractor.

3.  Relationship of the Parties.   How do you and your worker view your relationship?   Let’s say Eric, an electrician, wins a bids on a job for you at $30.00 an hour, estimates the job will take 400 hours, and agrees he’ll only gets paid for 400 hours and not an hour more.  He’s responsible for his own insurance, and also does electrical work for other customers obtained  through his Yellow Page advertising.  Eric’s relationship with you will not likely be judged as one of a W-2 employee.   You need not take out any payroll taxes, but should take care to obtain a Form W-4 from Eric at the beginning of the job, and you should also file a Form 1099 at year’s end.

The three examples above give you some general guidelines, but again, there’s 20 specific factors within these general guidelines, and since no 1 factor is controlling over the other 19.  So it’s difficult to know for sure how the IRS will classify your workers without requesting a determination from the agency. If you want the IRS to determine whether a specific individual is a contractor or an employee, file IRS Form SS-8.

DON’T BUY INTO ‘STREET MYTHS’

Don’t assume it’s safe to pay a worker on a 1099 basis simply because Uncle Fred or your cousin or someone from the neighborhood says they’ve been doing it– without penalty — for years.

Also, because there’s 20 different factors the IRS will look at, don’t assume it’s safe to classify a worker as a 1099 contractor simply based on one of the following situations alone:

  • The worker demands that he be paid via 1099
  • Other employers pay him as a 1099 contractor
  • The worker is doing work based on a contract that cover all the project details
  • The worker only does assignments for you sporadically, or inconsistently, or is on call
  • The worker is paid commission only
  • The worker uses his own tools and equipment
  • The worker does the same kind work for more than one company
  • The worker has his/her own business license or insurance

THE BOTTOM LINE

I often say to clients “Render to Caesar what is Caesars… but not a penny more!”.  In other words, we should do everything possible to avoid paying one penny more in tax than we are legally required to pay. But that doesn’t mean to evade taxes. No matter how fair or unfair the tax code appears to be, or how our competitors choose to operate, or how hard it is to pay our fair share….  our jobs as tax planners and taxpayers is to avoid taxes legally everywhere we can. But never evade paying them–because that’s not only illegal, but also can put you out of business.

ANCHOR ON THIS:    Avoid.   Don’t evade.   The former is your best strategy.  The latter would be your worst.

Posted in Small Business.

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