1099 Independent Contractor vs Employee [Updated 2020]
Many new business owners in the auto detailing and reconditioning industry pay their workers under the table. Obviously, this isn’t an issue limited to the car detailing industry. But it is a problem with numbers large enough to attract the attention of state and Federal tax agents.
The unfortunate result of cases like this is the obvious damage to the finances and reputation of their business. Sadly, it also creates an unfair perception with the public about the type of businesses that operate in this manner.
Since I often write about the business of auto detailing and reconditioning, taxes and insurance are two big subjects that I receive many questions about. Which is why I created this overview of 1099 independent contractors vs employees, updated for 2020.
Avoiding Taxes by Paying in Cash
There are many ways small business owners pay employees under the table. The most popular method is obviously cash. The person does the work and the business owner gives them cash.
The initial reaction by most people when they hear about cash transactions is that it’s illegal. It’s not. Cash, aka the almighty Dollar, is the official currency of the United States. You can pay for whatever you want with cash without raising an eyebrow anywhere.
The problem isn’t the cash unless you specifically choose to pay with it for tax avoidance purposes.
Cutting Corners or Raising Prices
This happens more often than you realize. Try requesting bids from contractors for any type of work on your house. You will no doubt have at least one or two that mention discounting the total cost for paying in cash. Why anyone would take that risk is crazy. But it still happens.
If you reach a point in your business career where the only way you can make a profit is by cutting corners in this manner, then you should raise your prices.
Or find a new career.
In the following sections, we will discuss 1099 Independent Contractors and how you can avoid misclassification of W2 employees.
1099 Independent Contractors
Many small business owners attempt to legitimize their payroll tax avoidance schemes by paying employees via check and calling them 1099 Independent Contractors.
Whereby the business owner treats the worker as an employee but pays them via check with no payroll tax deductions.
When the end of the year arrives, the business owner issues a Form 1099-Misc to the employee and the IRS. This form tells the IRS that the worker was paid via all those checks.
Why would the business owner do this to their valued employee? Most of the time it’s driven mainly by greed.
Only The Business Owner Wins
The only person that wins in this scenario is the business owner. They save having to pay the employer side of payroll taxes. And they avoid paying workers comp and unemployment insurance.
The largest win, by far, is the business owner can now deduct 100% of those 1099 contractor check payments as labor costs on their income tax return.
You should never treat your employees like this and let them work without workers comp or unemployment insurance. In my companies, we also provided disability and health insurance coverage.
Businesses should take care of their people.
Until the Tax Man Comes Calling
Unfortunately, now the worker/employee is liable for taxes on that income. So what do you think happens? Of course, they get angry. Maybe they get themselves fired.
Normally that wouldn’t be a big deal. People get fired every day. But this is the tricky part.
If you fire that independent contractor, they will immediately attempt to collect unemployment. You, the business owner, their boss, will be listed as their employer because let’s be honest, they had no idea how the 1099 independent contractor arrangement worked. And most wouldn’t care either way.
And that is the typical story of how many businesses get themselves on the radar of the taxman.
As you can see, paying anybody under the table is illegal and it hurts both your business and your employee. Plus, it opens a pandora’s box of legal issues with many departments within the State and Federal government.
When you pay your workers as 1099 contractors instead of W2 employees, you also make the IRS aware of this fact. They know auto detail shops are one of the many types of businesses that abuse the 1099 independent contractor classification. And all it takes is an audit to catch you. Then they tell their friends in your state revenue department and you have some sleepless nights ahead of you.
So how to you avoid these nightmare problems and properly classify 1099 Contractors vs W2 Employees?
How to Properly Classify 1099 Contractors
Two questions to ask in order to properly classify 1099 contractors are: who defines the end result; and, who controls the process?
From a business owner’s perspective, this means if your goal is to hire an independent contractor to complete a project, your involvement is limited to:
- Define the details of the project and the timeline to complete it;
- Negotiate a reasonable price for the work; and,
- Establish exactly what you want as the outcome or end result.
That is it. Then you step back and let the contractor do their work.
The contractor determines:
- How to complete the project;
- Which tools or equipment they need to use;
- The length of time to complete the work;
- How much to charge in order to cover their cost and earn a reasonable profit;
- And finally, when that project is actually completed.
And when the project is completed, you pay the contractor.
As you can see from this definition, you control the results, but the contractor defines the process to get the work done.
The contractor should also own their own equipment, control their own schedule, and maintain their own insurance. That last one, insurance, is very important and I will expand on that in more detail below.
The IRS will reclassify your detail shop, 1099 contractors, to employees by simply asking a few somewhat general questions:
- Do you tell these workers how to do their jobs?
- When to do their jobs? Are workers free to come and go as they please as long as they complete the work you assign?
- Who owns the equipment that workers use to perform their services? Do you provide equipment for them or do they arrive with their own tools, machines, and supplies?
- Do you have signed and executed contracts with each worker specifying what is expected of them and how they are paid for their work?
- Does each worker have their own liability insurance and worker compensation coverage? This is important if you are attempting to prove independent contractor classification during an audit.
- Do you train workers to do things your way? There are many companies that do this with contractors, you just need to be careful how you follow-up after the training.
- Do you set quotas, deadlines, or issue-specific instructions as to how long a worker is permitted to complete a project that you assign?
Did you answer yes to ANY of these questions? If so, then how many of your 1099 contractors are actually W2 employees? Most likely, all of them.
Learn the Rules or Hire a Professional
The ‘I didn’t Know’ defense is a bad idea. The Government won’t care. And it makes you look unintelligent for attempting to use that argument.
The IRS and State Revenue agents won’t care whether or not you understand the rules and regulations. That’s not their job. It’s actually yours.
As a business owner, you are expected to understand the rules, regulations, and laws that pertain to the type of business you own. If you don’t understand something, you hire a lawyer or accountant to explain it to you.
Or you can look it up on Google, which is most likely where you found this wonderfully informative article. Although as advice goes, it is always better to talk to a lawyer or accountant who knows your particular situation. Especially since I am neither.
My point is, you own a business so be professional and learn the rules or hire a professional to help you better understand issues that can ultimately cost you time and money to fix later.
The IRS Always Gets Its Money
You could be liable to pay ALL of the payroll taxes that both the employee and the business were required to pay for ALL the years that you did this.
They can also charge penalties and interest for all the years that you did it.
The really unfortunate part of this is in the majority of these situations the employee isn’t liable for those taxes, it’s on the business owner.
Even worse, if you can’t pay it or decide to shut down and declare bankruptcy, you’re still stuck. IRS taxes can’t be eliminated in bankruptcy. So they will still come after you for everything. The IRS always gets it’s money.
Correct Classification as W2 Employees
Pay your employees properly with the correct classification as W2 employees.
If that is indeed what they should be. You don’t want the stress of looking over your shoulder wondering when you might get caught.
If you can’t afford to pay the taxes that are due, then your costs are too high and the pricing model is wrong. Something is out of wack. So fix it.
You should be able to make money and run your business legally without having to cut corners like this. Otherwise it will end up being a huge problem for you down the road.
Continuing below is the criteria that the Federal Government uses to determine whether or not they are “employees” or “independent contractors”. This is from the IRS website at: https://www.irs.gov/businesses/small-businesses-self-employed/independent-contractor-self-employed-or-employee
Independent Contractor (Self-Employed) or Employee?
It is critical that business owners correctly determine whether the individuals providing services are employees or independent contractors.
Generally, you must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to an employee. You do not generally have to withhold or pay any taxes on payments to independent contractors.
Select the Scenario that Applies to You:
- I am an independent contractor or in business for myself
If you are a business owner or contractor who provides services to other businesses, then you are generally considered self-employed. For more information on your tax obligations if you are self-employed (an independent contractor), see our Self-Employed Tax Center.
- I hire or contract with individuals to provide services to my business
If you are a business owner hiring or contracting with other individuals to provide services, you must determine whether the individuals providing services are employees or independent contractors. Follow the rest of this page to find out more about this topic and what your responsibilities are.
Determining Whether the Individuals Providing Services are Employees or Independent Contractors
Before you can determine how to treat payments you make for services, you must first know the business relationship that exists between you and the person performing the services. The person performing the services may be –
An employee (common-law employee)
- A government worker
In determining whether the person providing service is an employee or an independent contractor, all information that provides evidence of the degree of control and independence must be considered.
Common Law Rules
Facts that provide evidence of the degree of control and independence fall into three categories:
- Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
- Financial: Are the business aspects of the worker’s job controlled by the payer? (these include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
- Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?
Businesses must weigh all these factors when determining whether a worker is an employee or independent contractor. Some factors may indicate that the worker is an employee, while other factors indicate that the worker is an independent contractor. There is no “magic” or set number of factors that “makes” the worker an employee or an independent contractor, and no one factor stands alone in making this determination. Also, factors which are relevant in one situation may not be relevant in another.
The keys are to look at the entire relationship, consider the degree or extent of the right to direct and control, and finally, to document each of the factors used in coming up with the determination.
If, after reviewing the three categories of evidence, it is still unclear whether a worker is an employee or an independent contractor, Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding (PDF) can be filed with the IRS. The form may be filed by either the business or the worker. The IRS will review the facts and circumstances and officially determine the worker’s status.
Be aware that it can take at least six months to get a determination, but a business that continually hires the same types of workers to perform particular services may want to consider filing the Form SS-8 (PDF).
Employment Tax Obligations
Once a determination is made (whether by the business or by the IRS), the next step is filing the appropriate forms and paying the associated taxes.
Employment Tax Guidelines
There are specific employment tax guidelines that must be followed for certain industries.
- Employment Tax Guidelines: Classifying Certain Van Operators in the Moving Industry (PDF)
- Employment Tax Procedures: Classification of Workers within the Limousine Industry (PDF)
Misclassification of Employees
Consequences of Treating an Employee as an Independent Contractor
If you classify an employee as an independent contractor and you have no reasonable basis for doing so, you may be held liable for employment taxes for that worker (the relief provisions, discussed below, will not apply). See Internal Revenue Code section 3509 for more information.
If you have a reasonable basis for not treating a worker as an employee, you may be relieved from having to pay employment taxes for that worker. To get this relief, you must file all required federal information returns on a basis consistent with your treatment of the worker. You (or your predecessor) must not have treated any worker holding a substantially similar position as an employee for any periods beginning after 1977. See Publication 1976, Section 530 Employment Tax Relief Requirements (PDF) for more information.
Misclassified Workers Can File Social Security Tax Form
Workers who believe they have been improperly classified as independent contractors by an employer can use Form 8919, Uncollected Social Security and Medicare Tax on Wages to figure and report the employee’s share of uncollected Social Security and Medicare taxes due on their compensation.
Voluntary Classification Settlement Program
The Voluntary Classification Settlement Program (VCSP) is an optional program that provides taxpayers with an opportunity to reclassify their workers as employees for future tax periods for employment tax purposes with partial relief from federal employment taxes for eligible taxpayers that agree to prospectively treat their workers (or a class or group of workers) as employees. To participate in this voluntary program, the taxpayer must meet certain eligibility requirements, apply to participate in the VCSP by filing Form 8952, Application for Voluntary Classification Settlement Program, and enter into a closing agreement with the IRS.
Proof of Insurance for Any Contractors
Another item that both Federal and State labor departments look for is whether or not the “contractor” has their own liability insurance. If they do that is a good sign that they have their own business and only work for you on a contract basis.
Your insurance company will also require you to provide proof of insurance for any contractors that you hired over the course of the policy term. If you can’t provide such proof then they will rate you and increase your premiums at the time of your annual insurance audit since you have exposed your insurance carrier to insuring “uninsured contractors” who work for you.
As I mentioned above, it’s also a nightmare if the government decides that the “contractor” is actually an “employee” resulting in you having to pay both your portion of the employment taxes and the “employee/contractor’s” portion plus penalties and interest. The Federal Government will also notify the local and state agencies and you will have to go through it all over again with them.
Be a Professional
Most of this is common sense. You are in business. It’s time to be a professional business owner. Otherwise, you will always be treated like a fly-by-night hobby instead of an actual business.
As mentioned previously, I’m not an accountant or an attorney, so you will have to consult with these experts to get details on how any of this applies to you and your business.
We just included this for information purposes so that you can ask your legal and tax people how to best incorporate these matters as it benefits you and your business.
The only advice I can offer from my own experience is to follow the rules and listen to the advice your legal and tax advisors offer you. It will save you a lot of money in the long run.