W2 or 1099 – The Painful Truth for the Wrong Answer

In today’s economy the question of “Am I an employee or independent contractor?” comes up quite frequently. This is also true for employers themselves as there are several types of tax that an employer must pay if the people performing work for them are deemed employees as opposed to an independent contractor.

Such examples are Social Security and Medicare Tax(FICA), Federal/State Unemployment Tax(FUTA) and Worker’s Compensation coverage. Additionally, a reason for employers’ motivation to mis-classify an employee is the compliance requirement for offering fringe benefits. At the end of the day a mis-classification can cost an employer – BIG TIME.

Under IRC 3509 if an independent contractor is deemed an employee the employer is subject to not only paying the employment taxes, but an additional 1.5% of the wages paid plus 20% of the employer’s share of FICA taxes(7.65% of wages paid).

An example of penalties assessed can be seen with a mis-classified contractor being deemed an employee who was paid $40,000 in 1 year. In addition to having to pay the employer’s share of FICA(7.65% or $3,060) and FUTA(0.6% or $42) the additional taxes of 1.5%($600) and 20% of the FICA($612) are assessed for a grand total of $4314.

For the employee themselves there’s the added pain of not having taxes with-held and having to pay both Federal and State(if applicable, remember, 7 states do not have an income tax) as well as their share of FICA.

The next question that arises is – why on Earth would an employee want to be paid on a 1099?

Simple – they can deduct work related expenses they wouldn’t otherwise be able to while being paid on a W2.

Back to our example of a worker being paid $40,000 for the year vs. contractor netting $40,000 in gross income to $30,000(75% of gross which would be the result of a lot of unreimbursed expenses- i.e. vehicle costs, cellphone/internet, etc) the difference is as follows:

Employee pays – $4824($3988 Fed + $950 AZ) or $5406($3988 Fed + $1418 IL)

Contractor pays – $6970($2165 Fed + $4239 SE Taxes + $566 AZ) or $7368($2165 Fed + $4239 SE Taxes + $964 IL)

As you can see having to pay the full amount of your own FICA taxes(known as Self-Employment Taxes) makes a huge difference and can be quite painful when you find out that balance due in April(while your employee friends are going on fancy vacations or buying new electronics with their large refund checks).

At least when you are an employee your employer normally has the Federal and State income withheld so come tax time you are usually looking at a small balance owed or even a refund. This does not even take into account under-payment penalties that would be assessed in addition to those balances above if you did not make estimated payments through-out the year.

Since taxes are such an individual situation with many variables it is best to talk to your income tax professional to find out 1) are you an employee or contractor?, 2) what tax strategies can you incorporate to keep more of your hard-earned money?

This goes for employers as well, as evidenced by the excess costs that can be assessed if you mis-classify your employees as contractors.

If you want to avoid the pain of excess taxes and penalties, please give us a call at 623-240-9545 and we will provide you with the relief you need!


Leave a Reply