A big, fat tax deadline is coming up on January 31, and it affects you, entrepreneurs: It’s D-Day to issue your 1099s and W2s. Unfortunately, it’s all too easy to make a mistake on these forms and there can be major consequences if you do.
But let’s back up: Why is it so important to understand W2s and 1099s in the first place, and how do you decide which form you need? The answer depends on whether the people who work for you are subcontractors or employees.
There is such widespread confusion about the legal difference between employers and subcontractors (or freelancers), and it’s a question I hear often from my bookkeeping clients. They aren’t so pleased when I tell them it’s not a question for me — it’s a question for the IRS, which has outlined very specific laws about who qualifies as what. Their faces cloud over even more after I let them know that making an incorrect decision may sink their business — and their financial boats — if they are ever caught.
There has been a huge shift in corporate and business culture over the last decade, which assumes — incorrectly! — that if someone works for you on a part-time basis, they’re automatically a freelancer. But that is just not the case. (And in fact, in days of yore, the opposite was assumed to be true. If someone worked for you part time or full time, they were “on the books.”)
The IRS has a well-designed guide to help you determine the nature of your relationship (and therefore which tax form to issue them). Sometimes referred to as “The Elements of Control,” the test is pretty simple: 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. But if they control their own schedule, work on their own equipment, maintain a roster of other clients, and you have written contracts in place detailing your working arrangement, then they are more than likely a subcontractor. (In the age of the “virtual assistant” and the “digital workforce,” arrangements are a little murky. If you’re unsure how to classify someone, check with your accountant or lawyer.)
Now you’re probably wondering — what’s up with all the confusion and misclassification when the rules seem pretty clear-cut? One answer (discounting ignorance): cost.
Even without offering health insurance or retirement benefits, an employee on staff means more money out of pocket for the business per hour. In addition to the per-hour or salary rate, the business must also contribute to their employees’ social security (an additional 6.2 percent on top of the base rate) and Medicare accounts (an additional 1.45 percent), pay into federal unemployment, pay into state unemployment, maintain and pay for disability and workers compensation insurance policies and, many times, pay an outside service to handle payroll.
But trying to cut costs upfront by misclassifying your workers can backfire — big time. I once had a client who was audited by the U.S. Department of Labor to determine if he had chosen the right classification regarding his labor force. He decided they were temporary or freelance workers, the department of labor didn’t agree. The result: about $10,000 in back taxes, penalties and accounting costs to help sort the whole mess out. It was one of the costliest mistakes he ever made in business.
So don’t be penny wise and pound foolish when it comes to deciding on employees or freelancers. If you’re sure your relationship is a freelance arrangement, hire a lawyer to draw up an agreement that indicates it. 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. Shelling out a little more money per hour now may help you avoid more costly problems down the road.