Q. What is the best way to do payment deduction for 1099 workers for things like equipment, insurance, and other services on an ongoing basis?
We do not know the details of your business arrangements with these workers or the precise expenses you want to deduct from their compensation, but payroll type deductions from the compensation paid to workers engaged as independent contractors are uncommon and can be problematic. Independent contractors typically provide their own equipment and pay their own payroll taxes and insurances, including workers’ compensation, health insurance, and bonds. Making deductions from an independent contractor’s pay for “equipment, insurance and other services” provided to the worker that he or she would traditionally pay for directly when properly classified as an independent contractor could jeopardize the worker’s status as an independent contractor. As can allowing independent contractors to participate in a company’s employee fringe benefit plans, like accident and health plans, retirement plans, etc.
If you are uncertain about the proper classification of workers you engage for your business, you should review the details of their responsibilities with your business lawyer to assure that you handle their compensation, payroll taxes, and insurance in accordance with labor and tax regulations. For discussion with your lawyer and to help understand the differences between worker classifications, the following is information on the considerations when engaging workers as independent contractors.
Independent contractor classification considerations
Independent contractors pay their own payroll taxes and insurances, including workers’ compensation and bonds, and are not covered by many labor laws, so the financial and administrative benefits of having a workforce composed of independent contractors can be significant. However, it is crucial for business owners to understand that independent contractor status is not an arbitrary election but is based on the job structure and level of control the party who engages the worker exerts over how the worker performs that job. It is also important to understand that independent contractor status cannot be established or supported by the completion of any particular forms or tax paperwork (like Form 1099-MISC), the drafting of a carefully worded offer letter or an independent contractor agreement, piece work, commission, or other performance-based compensation method, or by part-time, project based, seasonal or other short-term work arrangements.
Misclassifying workers as contractors can have labor law, employee benefits, employment tax, and workers’ compensation implications for businesses and the affected workers. For example, making the wrong determination of a worker’s status can result in IRS and state tax audits with back tax assessments that can be ruinous to a small business; therefore, it is important that a business owner understand the criteria that the IRS and state authorities use in determining whether a worker is properly classified as an employee or an independent contractor.
Whether a particular worker qualifies as an independent contractor with regard to the services provided your business will depend on all the facts and circumstances. An independent contractor is a legal category of worker defined by the Internal Revenue Service. The basic difference between an independent contractor and an employee under the IRS definition is that, unlike employees, independent contractors retain control over how the work they are hired to do gets done; the person or company paying the independent contractor controls only the outcome – the product or service. With an employee, by contrast, the person or company paying an employee controls not only the outcome of the employee’s work, but also how the work they do gets done. In order to determine whether a worker qualifies as an independent contractor rather than an employee, the worker’s job and the control you exert over the worker must be evaluated under what is known as the common law right of control test. Under this subjective test, for which the IRS developed a 20-factor analysis for its auditors, the IRS basically takes the position that if you tell a worker what to do and how to do it, then that worker is an employee. To add to the classification difficulty, state government agencies often use different criteria than the IRS for classifying workers as employees or independent contractors for state tax and workers’ compensation purposes and some states can impose severe penalties under state law on businesses that misclassify workers as independent contractors. Since the potential penalties for misclassifying a worker as a contractor rather than an employee can be severe, you should clarify with your business lawyer that a worker’s job meets the IRS criteria for independent contractor status before engaging the worker.
You can also review more in depth discussions at the following IRS websites:
http://www.irs.gov/pub/irs-pdf/p15a.pdf (see 2. Employee or Independent Contractor?)
Regardless of the business structure, it is advisable to have written agreements with qualified independent contractors to explain the job responsibilities, compensation arrangements, tax and insurance responsibilities, and other important terms of the arrangement. Businesses typically have insurance provisions in written independent contractor agreements that explain the required insurance coverage (liability, workers’ compensation, bond, etc.) and that require contractors to provide a Proof of Insurance Form that demonstrates that they have the insurance required under the contract. In addition, it is advisable for businesses that use independent contractors to obtain the proper liability insurance coverage to protect themselves from the actions of contractors who fail to maintain the required insurance or are otherwise named in legal actions involving their contractors. You should consult your business insurance agent to determine the recommended insurance coverage and other risk management implications when engaging independent contractors.
Contractor tax reporting
Form 1099-MISC. Under current tax law, businesses report cash and check payments for services rendered by non-corporate vendors, such as qualified independent contractors, on Form 1099-MISC, which is filed annually and, in the case of services, only when payments total $600 or more during the calendar year. Businesses are required to provide non-corporate vendors with copies of Form 1099-MISC for the preceding calendar year by January 31st. Copies of Forms 1099-MISC also must be submitted to the IRS and certain state taxing authorities for the preceding calendar year by February 28th; however, most states obtain their 1099 information through data sharing arrangements with the IRS. Forms 1099-MISC submitted to the IRS must be accompanied by Form 1096, Annual Summary and Transmittal of U.S. Information Returns. Forms 1099-MISC and 1096 must be submitted to the IRS electronically or using machine readable (optically scanned) forms that you can order directly from the IRS at 1-800-TAX-FORM (1-800-829-3676). You can find and review Forms 1099-MISC, 1096 and the filing instructions at the following IRS websites:
2016 tax year forms (for reporting amounts paid in calendar year 2016):
Form 1099-K. It is important to note that businesses only report cash or check payments on Form 1099-MISC. Payments made by credit or debit cards as well as those made through third-party networks such as PayPal, Amazon.com and Google are reported by the payment processors on Form 1099-K. The following is IRS and related information on the topic:
However, the regulations contain an “aggregate payee” rule that requires companies who accept credit or debit card payments and third party network payments for other parties who work for them as independent contractors to report those payments on Form 1099-K. You can review Form 1099-K and its instructions at the following websites:
2016 tax year forms (for reporting amounts paid in calendar year 2016):
Form W-9. The basic tool to properly identify and manage your Form 1099 reporting and potential tax withholding obligations with vendors is Federal Form W-9, Request for Taxpayer Identification Number and Certification. Form W-9 is used by businesses to obtain a vendor’s, including an independent contractor’s, TIN or Taxpayer Identification Number (Social Security Numbers in the case of an individual or Federal Employer Identification Number (EIN) for a business) and to have the vendor certify that they are not subject to backup withholding. When a vendor fails to provide you with a TIN, you will be required to withhold federal income tax from your payments to that vendor under the backup withholding rules. For 2016 the backup withholding rate is 28%. You can locate Form W-9 and instructions and review the backup withholding rules at the following IRS websites: