What is the difference in Independent Contractors VS Employees
If you have found yourself asking why your boss has paid you as a 1099 independent contractor instead of a w-2 employee, look no further. There are various tax implications for individuals who receive these, and reasons for an employer to do this, but first you must understand the differences between the two.
What is a 1099 Independent Contractor?
A 1099 form is issued to an “independent contractor” at the end of the year, rather than the common W-2 form that most employees receive. The differences between the two are much more than the different form numbers. An independent contractor is often simply defined as an individual or sometimes even a company that executes a service for another person or company. Under this professional classification contractors are seen as “self-employed”.
Furthermore, this classification comes with many benefits such as: the freedom to choose which services they will offer, their daily schedule, their workplace, their work supplies, their work tools and expenses, and many other things they may need to accomplish their service. In optimal circumstances they have a professional contract in which their scope of work is defined. This is the primary distinction between a typical employee and an independent contractor.
What is a W2 Employee?
Conversely, a traditional W-2 employee works for an indefinite period. The employer controls services performed, their role, their schedule, and provides all materials associated with their work. Before the popularity of “hybrid scheduling” or “work from home”, it was commonplace for employers to facilitate a physical location for their employees to work.
How do I know W2 or 1099?
The IRS has issued a set of rules and criteria for determining a worker’s status called the “Common Law Rules” for employees and employers to better understand how you should be classified or how employers should classify their workers. This set of rules is broken into three distinct categories: Behavioral Control, Financial Control, and Type of Relationship.
1.Behavioral Control
This first criteria refers to the level of control an employer has over an individual’s work or service. This means a worker must be classified as an employee when they are instructed when, where and how to
work.
According to the IRS, behavioral controls include:
- Type of Instructions Given: If the employer commands when, where, and how to work, it suggests an employer-employee relationship.
- Degree of Instruction: The more detailed the instructions, the more control the business owner has over a worker.
- Evaluation Systems: If an employee requires to be evaluated by the company’s owner, this indicates employee status.
- Training: If the company provides the worker with job training, this means the company wants. the job done in a specific way which is evidence the worker is an employee. Independent contractors work according on their own experience, training, and methodology.
2.Financial Control
This criterion refers to factors that show the degree of the control the company’s owner has over a worker economically.
According to the IRS, financial control includes:
- Significant Investment: An independent contractor commonly has a significant investment in the equipment they use. An employee does not.
- Unreimbursed Expenses: Commonly independent contractors have more unreimbursed costs than employees.
- Opportunity for Profit or Loss: If a worker has a significant investment in the tools and equipment, the opportunity to make or lose money increases. This indicates independent contractor status.
- Services Available to the Market: An independent contractor is free to seek out multiple, and most likely simultaneous, business opportunities.
- Method of Payment: Employees are guaranteed a regular hourly, weekly wage amount (or any other scheduled). Independent contractors usually provide an invoice that list a fee, or an hourly rate.
3.Type of Relationship
This criterion refers to factors that illustrate how a worker and business perceive their working relationship.
According to the IRS, these factors include:
- Written Contracts: Even if the worker’s classification is in a written agreement or statement, the IRS does not see this as a sufficient means of determining the worker’s status. It is the nature of how the parties work together that determines if a worker is an employee or an independent contractor.
- Employee Benefits: Businesses generally do not provide employee benefits to independent contractors.
- Permanency of the Relationship: A worker who expects the relationship to continue indefinitely is typically an employee.
- Services Provided as Key Activity of the Business: A worker who provides services integral to business operation such as an attorney working for a law firm, is more likely directed by his or her employer (employee status).
How to prepare for taxes as an Independent Contractor?
As an independent contractor you are responsible for filing a Schedule C on your individual tax return and paying quarterly taxes if applicable to the amount you earn. On top of your federal state and income tax that you already must pay, as an independent contractor you also must pay an additional 15.3% in self employment taxes. This tax consists of the Social Security and Medicare taxes that would usually be withheld by an employer of a salaried or W-2 employee.
This additional self employment tax can get very costly, so check out our blog post on how to avoid this additional tax by setting up an S Corp HERE. (planning to post around 8/23/22)
In order to determine how much you must pay in self employment and income taxes you must calculate your net profit. To do so you must subtract your business expenses from your business income. If your expenses are less than your income, the difference is net profit and become part of your income on the first page of your form 1040 or 1040-SR.
When a payment to someone who is not an employee (such as a subcontractor, attorney or accountant) is more than $600 for services rendered during the calendar year, a form 1099-NEC needs to be completed and provided to the independent contractor by January 31 of the following payment.
How to prepare for taxes as an employee?
Consequently, knowing your employment status and how to properly classify your workers is vital to maintaining the compliance of your business and knowing the best route to prepare for your taxes.
W-2 employees have much simpler tax requirements and preparation for their tax returns. Their taxes can easily be mitigated by ensuring proper withholding throughout the year depending on their annual salary and earnings.
While 1099 employees or independent contractors are subject to additional taxes and scrutiny by the IRS, they are also allowed more deductions and tax credits depending on their industry that can help them to build a successful business. The best way for people who fall under this classification to prepare for taxes, is to make sure they are saving enough money to pay their taxes, making quarterly payments, keeping accurate records of all their expenses (mileage, materials, legal fees, office expenses, etc.), and working with knowledgeable professionals for tax planning.
With the counsel of a seasoned accountant, like one of our tax advisors at Molen & Associates, you can succeed. Call us today, seriously. You’ve read this far; you know you need us!
Edgar Castillo
