Taking on 1099 employees has advantages and disadvantages.

The lure of classifying a worker as an independent contractor pales in comparison to the hefty fines and penalties associated with such a misclassification even if it were unintentional.  

As an independent contractor, you should set aside enough funds to cover FICA and income taxes. Consider setting up a separate bank account for taxes and making periodic payments to the IRS.

Accepting 1099 Workers Is Simple

In today’s gig economy, many employers are finding it convenient to hire independent contractors to fulfill crucial roles. Rather than receive a W-2 at the end of the year like regular employees, independent workers receive IRS form 1099. The biggest difference is while employees have federal and state, Social Security and Medicare (FICA) taxes withheld each pay period, independent contractors avoid these taxes. This makes it simple when it comes time to pay 1099 workers. The company avoids having to calculate payroll taxes and doesn’t have to pay its portion of payroll taxes which is half of the FICA tax, 7.65% of the current threshold of an employees annual salary up to $128,400. The employer also avoids paying the Federal Unemployment Tax Act (FUTA) for independent contractors. So for example, if you take on an independent contractor on January 1 and agree to pay her a monthly fee of $5,000 over the course of the year, at the end of the year she’ll receive Form 1099-MISC showing her annual compensation as $60,000. When Uncle Sam comes calling, she’ll be responsible for paying taxes on the $60,000.

States Have Strict Guidelines on Employees Versus Contractors

Sounds like a win-win for both you as the employer and for the independent worker. However, when it comes to taxes, the IRS and states say not so fast. The government wants to make sure that as an employer, you’ve classified workers properly. In other words, tax officials want to ensure that employers are looking to avoid paying state taxes by classifying a worker as an independent contractor rather than as an employee. In general, states have strict definitions of what constitutes an independent contractor. From California’s Department of Industrial Relation’s website, the state applies an economic realities test which includes whether the employer has control or right to control the worker and the manner in which the work is being done. Additional factors include:

  1. Whether the person performing services is engaged in an occupation or business distinct from that of the principal;
    2. Whether or not the work is a part of the regular business of the principal or alleged employer;
    3. Whether the principal or the worker supplies the instrumentalities, tools, and the place for the person doing the work;
    4. The alleged employee’s investment in the equipment or materials required by his or her task or his or her employment of helpers;
    5. Whether the service rendered requires a special skill;
    6. The kind of occupation, with reference to whether, in the locality, the work is usually done under the direction of the principal or by a specialist without supervision;
    7. The alleged employee’s opportunity for profit or loss depending on his or her managerial skill;
    8. The length of time for which the services are to be performed;
    9. The degree of permanence of the working relationship;
    10. The method of payment, whether by time or by the job; and
    11. Whether or not the parties believe they are creating an employer-employee relationship may have some bearing on the question, but is not determinant since this is a question of law based on objective tests.

California, as with the other states, will consider the worker as an employee if any of one of the above-mentioned conditions exist.

The High Consequences of Misclassifying Workers

Given the loss of tax revenue, both the federal and state agencies take the issue very seriously. The Department of Labor (DOL) and state agencies will typically perform audits that look at all employees over a three-year period. Penalties for improperly reporting a worker as an employee depends on whether the misclassification was intentional, unintentional or even fraudulent. According to Justworks.com, an estimated 3.4 million workers are classified as independent contractors when in fact they fall under the classification of employees. An unintentional misclassification brings with it a $50 penalty for each employee that should’ve received a W-2 rather than Form 1099. In addition, the employer faces a penalty of 1.5% of wages plus 40% of FICA taxes including accrued interest. The IRS also imposes a penalty of 0.5% of the unpaid tax liability for every month up to 25% of the total tax liability. If the IRS suspects fraud, it can impose penalties of 20% of all wages and 100% of the FICA taxes, which includes the employee’s portion. Then there are the criminal penalties which can amount to $1,000 per misclassified worker, which can include one year prison time.

In a case against Paul Johnson Drywall Inc, the company agreed to pay $600,000 in back wages for misclassifying former workers as “member/owners” instead of as employees after entering into an agreement with Arizona Tract LLC, a construction labor contractor. The company forked over $556,000 in overtime back wages to at least 445 employees and $44,00 in civil monetary penalties. Recently, ride-hailing service, Uber, found itself in the middle of the employee versus independent contractor controversy, which would’ve had major financial implications for the company. However, a federal judge on the United States District Court for the Eastern District of Pennsylvania upheld that Uber drivers are independent contractors citing that:

“Uber places no restrictions on drivers’ ability to engage in personal activities while Online, and Plaintiffs here, in fact, engaged in a range of personal activities while Online. The undisputed facts in the record reflect that, while Online, Plaintiffs, inter alia, accepted rides from private clients, slept, did personal errands, smoked cigarettes, took personal phone calls, rejected trips because they were tired, and conducted business for their independent transportation companies . . . . Drivers also sometimes forget to go offline, such that they remain in the Online mode on the Uber App despite having no intention of completing trips. . . . Drivers are allowed to use software applications other than the Uber App and to provide transportation services to others “outside of” the Uber App.”

Implications for Independent Contractors

While the thought of not having to pay taxes is appealing, it’s important to make sure that an employer is not mislabeling you as an independent contractor. For starters, as an independent contractor, you are not entitled to unemployment benefits once the employer ends your employment. In addition, independent contractors are not entitled to employee benefits such as health insurance, 401K or other company perks. Pretty much you have to fend for yourself. As an independent contractor, you’re still responsible for withholding the proper amount of income taxes and FICA tax, which in this case amounts to 15.3% of wages, as the employer is not liable for paying its half of the tax.

If you do happen to fall under the category of an independent contractor there are a few things to consider. First, at the very minimum, set aside enough money to cover FICA taxes. You should also cover your income tax liability. While it is tempting to pocket all of your pay, you don’t want to get hit with a huge tax bill come tax time. According to Kevin Hanna, CPA, as a general rule of thumb, you should earmark about 30% of your income for income taxes. However, this will depend on your overall income tax bracket so its best to seek the advice of a qualified tax professional. It’s also a good idea to set up an account with the IRS through its Electronic Federal Tax Payment System (https://www.eftps.gov/eftps/). Once set up, you can send in estimated tax payments throughout the year. The IRS likes that and even if you overpay, you can count on a tax refund check, which is always nice.

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