Today there are more freelancers or independent contractors working in the U.S. than ever before. The advent of this “freelance economy” offers many benefits such as flexibility and cost savings, allowing business leaders to focus on growing their operations. At the same time, choosing to hire freelancers can present unique challenges such as compliance concerns, potential legal issues and of course tax implications.
When it comes to the latter, you may be asking yourself questions such as “how do I determine whether to pay a worker as a W2 employee or a 1099 contractor?”
It can all seem so overwhelming. But in this post, we’ll break down the IRS rules and the steps you need to be aware of when it comes to preparing and filing 1099’s.
While the following notes do not constitute any type of tax advice, they offer a good starting point when it comes to thinking about your small business tax preparation needs.
Effective this year, the IRS has changed the filing date for form 1099-MISC Reporting for Nonemployee Compensation in box 7. Forms must now be issued a month earlier, by January 31st each year. Please note that the filing dates remain unchanged for form 1099-MISC that Do Not Report in box 7.
Apart from due dates, it is also important to know that you only need to complete a form 1099 if you exceed the IRS’ threshold of $600 in cumulative payments to independent contractors for that tax year. You will not need to submit documentation to the IRS for any contractors who did not receive $600 or more in gross payments for the tax year.
HOW DO YOU DEFINE 1099 CONTRACTORS?
Your company’s tax liability is determined by the worker’s employment status. Therefore, if you onboard an “employee,” then you are required to pay state and federal employment tax, social security tax and worker’s compensation / disability premiums to a State Insurance Fund. In this situation, you will issue a W2 form to this employee.
On the other hand, “independent contractors” are responsible for their own self-employment taxes. For contractors, you will file Form 1099-MISC for miscellaneous income paid to these nonemployees.
But how do you go about defining a W-2 employee vs a 1099 independent contractor? Or better yet, how does the IRS define a W-2 employee vs a 1099 independent contractor?
The IRS offers guidance on this classification stating that “an individual is an independent contractor if the payer has the right to control or direct only the result of the work, not what will be done and how it will be done. Small businesses should consider all evidence of the degree of control and independence in the employer/worker relationship.”
They go further by providing these three categories to consider when defining the status of a worker:
Behavior A worker is classified as an employee when the business has control or the right to control the work performed. Designating where the worker will perform his or her duties and providing training are good examples of behavioral control. For independent contractors, the focus is on the end result (project deliverable) instead of the methodology.
Financial An employee is generally paid a regular wage on an hourly, weekly or monthly basis whereas independent contractors typically charge a flat fee. If the worker is able to provide simultaneous services for multiple unrelated businesses or they pay for their own business travel, they are a contractor. Employees will generally be solely (primarily) reliant on your business for their income.
Type of Relationship Written contracts and employee-type benefits generally mean you’ve hired an employee. The permanency of the relationship is also a key determinant here. Contractors are usually hired for time-specific projects whereas for employees, the expectation is that the relationship will continue indefinitely.
The key takeaway is that, as a business owner, you will have a lot less control over contractors compared to employees.
It is also important to note that incorrectly categorizing workers can result in serious implications. In the case of an audit, there’s a good chance that your business could be liable for past FICA, federal unemployment taxes and/or state income tax withholdings.
In addition, under the Fair Labor Standards Act (FLSA), you could also be liable for unpaid overtime for any miscategorized workers.
For more detailed information directly from the IRS, please reference IRS topic 762.
Before you can start printing your 1099’s, you will need to establish a list of vendors who should be classified as 1099-eligible based on the guidelines above. Generally speaking, 1099s will not only be issued to independent contractors but also service providers. An example of the latter would be janitorial services for your small business.
In addition, the IRS also stipulates that “Attorneys' fees of $600 or more paid in the course of your trade or business are reportable in box 7 of Form 1099-MISC.” There are some other cases to consider when supplying 1099’s for certain LLC’s, sole proprietors or C corporation that we won’t go too deep into for the purposes of this post.
Please remember that if you do not issue a 1099 when it is required then it is highly likely you will be penalized in the case of an audit. Therefore, it’s always better to err on the side of caution if you’re unsure. Or better yet, seek the advice of a tax professional to assist you with your small business tax preparation needs.
If you use QuickBooks Online to meet your small business accounting needs, then you will be pleased to know that the software can be used to print form 1099-MISC. However, you must have an upgraded “Plus” account in order to enjoy this benefit.
If you have a lower-tiered package, you won’t be able to access this feature.
TIP: If you aren’t sure which version of QBO you’re currently running, then you can check your account using the following steps:
Click the gear icon and select “Your Company”
Double click “Account and Setting”
Then select“ Billing & Subscription” to see if you have one of the following packages: Essentials, Simple Start or Plus.
Best practices dictate that you request a W9 from all new consultants, contractors and legal firms in order to stay organized. Once you have this information, you can go ahead and set up vendors in QBO using the following guidelines:
Pull up the Vendors tab, located in the far-left menu bar.
Search for the vendor for whom you wish to add W9 information. We will focus on independent contractors and individuals as our vendors for the rest of this tutorial.
You can now save the payment information for the purpose of issuing a form 1099-MISC for the tax year under review.
Enter the contractor’s tax ID (including any dashes in the number). This will either be their EIN or Social Security Number. It is important to note that not all contractors will have an EIN and some will use their SSN. It depends on whether they are filing as self-employed or not.
Be sure to check the box “Track payments for 1099.” We recommend entering this information for all new vendors even you aren’t sure you’ll need to print a 1099 for that worker. However, including this information when you set up your vendors in QBO will help save you time and prevent headaches during tax season.
Ensure that you keep a hard copy as well as a digital copy of the W9s for each vendor account you created.
PREPARING TO PRINT 1099-MISC FORMS
Quickbooks Online provides a setup “wizard” to assist you with preparing to print your company’s 1099-MISC forms. If this is your first time printing the forms via QBO, then you may have to complete some additional steps to complete your company file.
To get started, select the Vendor option from the left menu bar.
Next to New Vendor select Prepare 1099’s as illustrated below.
Once you begin to set up printing form 1099-MISC, QuickBooks will prompt you to review your company data. Review each section to ensure all reported company information is correct including your company name, address and EIN. This information will be printed on all documents to be issued to vendors and the IRS, so accuracy is very important.
ASSIGNING VENDORS TO 1099 CATEGORIES
Next, select the boxes of the 1099’s you want to set up mapping for. Since most small businesses work with contractors, the focus will generally be on box 7 “Nonemployee Compensation.” This box is used to track third party contractors or individuals that are not on your payroll but who received payments during the tax year. Within the 1099 setup “wizard” place a checkmark next to box 7 to indicate nonemployee compensation.
Next, locate the drop-down menu, right below box 7. This step can be easily overlooked since there is no pop-up box. Here you will only select your expense accounts and not your income accounts. Income accounts aren’t reportable for the purpose of 1099.
Select only the expense accounts that are related to the contractor’s earned income only. Reimbursements made to contractors should not be recorded on the 1099 as income because only earned income should be reported in box 7. Let’s say for example, you paid a contractor $1,000 in March. Of that amount, direct labor accounted for $800 whereas the remaining $200 was allocated as a reimbursement for related materials the contractor purchased during the project. In this case, you would not issue a 1099 for $1000 but instead $800 should be recorded since this is the earned income the contractor received for completing the job.
Now that the expense accounts from your chart of accounts have been selected for reporting, QuickBooks will generate a list of vendors that should receive a 1099. Please note that this list will only include vendors who you previously selected to track for the purpose of filing a 1099 based on W9 information provided during vendor setup.
At this stage, it is important to take some time to review vendor information. If there happens to be an error with the address or a vendor needs to be deleted, you can easily make edits by clicking the blue edit button. You can also change the vendor’s mailing address, EIN, or any other contact information.
Now that accounts and vendor files have been selected, QuickBooks will filter your vendor list based on the following criteria: vendors who meet the threshold, vendors who do not meet the threshold, or vendors not marked for 1099s.
For this tutorial, we will filter by vendors who meet the threshold.
Choose whether you would like to file electronically (there’s a fee) or print and file.
If you select the print and file option you will need to order readable IRS approved 1099 forms.
Please note that the 1099-MISC is a multi-part form. Here is a brief summary of each part of the form and where you will need to send each copy:
Copy A is sent to the IRS
Copy 1 is sent to the state tax department(s)
Copy B is for the recipient
Copy 2 is for the recipient to file with their state income tax return
Copy C is for the payee (you)
Form 1096 summary of totals included in 1099 that is sent to IRS with Copy A
Small business tax preparation can be a daunting and time-consuming task. And, now, with the shorter time frame for filing 1099’s, the process can be more overwhelming than usual.
At Ignite Spot, we know first hand just how busy you are as a small business owner. Our accounting and bookkeeping services will allow you to focus on your business and free up your time from doing paperwork and filling out complicated tax forms. We specialize in small business tax preparation for businesses that utilize our bookkeeping or CFO services.
The CPA team at Ignite Spot is ready to build the best possible small business tax preparation strategy for you and your company all at a fraction of the cost of hiring someone in-house. Give us a call today to see how we can meet your needs.