Is Your Freelancer Really Your Employee?
W-2s and 1099-MISC forms can sometimes be the cause of confusion and even anger on the part of employees. Why? Many employers are issuing 1099s to workers who could potentially have believed they were employees all year long. They may have received W-2s in the past, then the employer reclassified them to independent contractors. Or, they got a W-2 for their wages, but all their reimbursements or business allowances showed up on a 1099-MISC.
Why are employees so angry? Because workers who believe themselves to be an employee for tax purposes count on their employers to pay them as employees — to take care of their withholding and payments to the IRS, to give them sick days and vacation days—even if they don't get any health or retirement benefits. And most of all, employees count on employers to pay their share of the taxes (e.g. 7.65% share of Social Security and Medicare costs) as well as the cost of the state and federal unemployment insurance and state disability where applicable.
Ultimately, workers’ dissatisfaction may result in an IRS audit, because professionals and tax columnists are telling your employees how to beat the extra taxes. The workers that want to keep their jobs until they can get a new position will wait to file an amended tax return until after they leave their position. After all, they have three years to amend their tax returns, turn you in, and get refunds.
What can workers do if they feel they’ve been misclassified?
- Employees who received Form 1099-MISC can use Form 8919 to pay only their half of the Social Security and Medicare taxes (7.65%) instead of the full self-employment taxes (15.3%) – half of which is the employer's responsibility.
- If they received both a W-2 and 1099-MISC, they can just use Code H on the Form 8919 and don't need to include more detailed forms. The IRS will notice, but they may only send a letter telling you how to treat their compensation correctly.
- However, if they only received a 1099-MISC, they will also have to fill out a Form SS-8. This is a 4-page questionnaire – Determination of Employee Status. The IRS will be contacting you to confirm or deny your employee's contention that they are not contractors. This may result in a full-blown audit of your payroll practices for the past 3-4 years.
- If you issued their mileage or employee reimbursements on a 1099-MISC, you're paying them incorrectly. These reimbursement rules are not new. They have been effective since January 1, 1989. There are currently only two ways to handle these kinds of payments. Via an 'accountable plan' or a 'non-accountable plan.'
a) Under the 'accountable plan' your employee submits expense reports to you, with the receipts (or copies of them), mileage reports, and any other required substantiation for their expenses. You pay them based on those receipts. If you advance them money for a trip, they must return any excess within 120 days, or the excess gets added to their wages. That excess will be fully taxed – income taxes, FICA, Medicare.
b) Under the non-accountable plan, you just give them a check without asking for any verification. It might be a flat amount each month or it could vary. It might be an auto allowance, or payment for so many miles a month, or meal allowance, or whatever. Since they are not providing you with any substantiation, the full amount gets added to payroll. This is fully taxed – income tax, FICA, Medicare. At no time do you issue a 1099 for these funds.