I Am a Contractor – Why are They Taking Out Taxes?

 What is the difference between a 1099 employee, a W-2 employee and a contractor? And what is the advantage to each?  Well, more and less than you might think.  It is all a matter of CONTROL. 

The more control the person writing your paycheck has, the more likely you are an employee.  A 1099 employee is in reality an independent contractor.  However, not every contractor qualifies as a 1099 employee.  In essence, if you are working for a company that directs where and when you are to show up for work, tells you when and what you are to work on, and provides you with equipment, i.e. the company has CONTROL, you are a W-2 employee.  

The true 1099 employee directs his or her own work, provides his or her own equipment, works on a project basis, and has MORE THAN ONE CLIENT.    A project can be defined by a timeframe, but once the contractor starts working, they are on their own to complete the objectives.  Many times the independent contractor actually has his or her own company and may have employees of their own. 

Independent contractors are paid based on the project (which can be time and materials, or a flat rate, or even hourly), but there is no legally set payment schedule (unlike an employee receiving a salary).  Payments are not in the form of paychecks (an employee term) but are made on invoices and can be delayed by normal corporate payment schedules.  All pay is reported to the IRS on a 1099, and taxes are the responsibility of the independent contractor.  While this may sound attractive, the independent contractor is subject to self-employment taxes, paying both sides of the FICA equation.  A Schedule C is generally filed. The independent contractor must also cover his or her own insurance and benefits.

In contrast, the W-2 employee, who can be a contractor hired for a short period of time, or a permanent employee, is paid a salary or on an hourly basis, and taxes are deducted from his or her paycheck.  The employer pays half of the FICA equation, as well as providing unemployment, workers' compensation, other insurance and benefits.  Wages are reported to the IRS on a W-2 and a 1040 tax form is filed. 

The IRS often challenges independent contractors who are in reality W-2 employees.  Many independent contractors under-report, or fail to report, income received on 1099s.  Schedule C forms are not filed, and self-employment taxes are not paid.  But the contractors are not the only issue for the IRS.  Companies have used the independent contractor status to avoid providing benefits, paying overtime, or paying employment taxes.  The penalties imposed by the IRS for failing to properly categorize workers include fines and penalties as well as back taxes and interest. 

It is also important to note that the issues do not stop with the IRS.  These are cascading problems.  Once the IRS is involved, there are other federal and state agencies which are brought into the matter, and state taxes to pay as well. 

If you are an independent contractor, make sure that you truly are independent. If not, you are most likely an employee, and should be entitled to the payment terms and benefits of an employee. 

 From a company standpoint, it is important to properly categorize your employees and independent contractors, or face the consequences.