When you’re starting a small business, there are so many things to worry about. One of the most consequential decisions you can make concerning your business is when, and how, to bring employees on board. You’ll need to decide whether those workers should be full-fledged W-2 employees or independent contractors. 1099 independent contractors can sometimes be more cost-effective than employees, but this option isn’t available to every employer.
What is a 1099?
There are several 1099 forms, but Form 1099-NEC, Non-Employee Compensation, is the one used for independent contractors and freelancers.
Businesses are required to withhold taxes for their salaried employees, but independent workers have to keep track of their own taxes because they’re considered one-person businesses.
Who needs a 1099?
When you hire an independent contractor, you (the business owner) must file a 1099-NEC if they’re paid $600 or more. This lets the IRS know how much in taxes they can expect from the freelancer. You also need to send a copy of the 1099-NEC to the contractor. It’s important to note that this only applies to businesses hiring contractors. Private citizens who hire contractors don’t have to file a 1099 on their behalf.
For example, if you hire an electrician to replace the light fixtures in your office building, you’ll have to file a 1099 and send a copy to the electrician. On the other hand, if you hire the same electrician to install wiring in your home, you won’t have to issue one.
Here are the types of business entities you’ll issue a 1099 to:
- Sole proprietorships
- Partnerships/limited liability partnerships
- Limited liability companies (that aren’t taxed as corporations)
- One-person limited companies
When it comes to taxes, sole proprietorships, general partnerships, and limited liability companies (LLCs) are considered pass-through entities (unless an LLC files to be taxed as a corporation). This means that any income is taxed on an individual’s tax return, as opposed to the business itself.
Here are the businesses that usually don’t get a 1099-NEC form:
- Businesses that choose to be taxed like a corporation
On the other hand, C corporations (the default form of corporation) are double-taxed, once for the business, and then again on a personal level. However, there are a few situations when you’ll issue a 1099-NEC even when the contractor is incorporated. These include:
- Lawyer costs for legal services and gross proceeds to a law firm, like settlements
- Medical payments to for-profit care providers
To fill out a 1099, you’ll need some information from your contractor. The easiest way to get this is to have them fill out Form W-9 when they begin working for you. Some of the information you’ll need includes:
- Their name
- Their business name (if it’s different)
- Their address
- Their taxpayer filing status
- Their exemptions
- Their Social Security number (SSN) or employer identification number (EIN)
Extensions, Amendments, and Penalties
If you don’t file the necessary 1099s for the contractors that your business hires, you may face some issues. If you file late, you’ll have to pay $50 per late form up to 30 days, $110 per late form until Aug. 1, and $270 per late form after that. If you purposely don’t file Form 1099-NEC, the fine shoots up to $550 per late form. These fees are subject to change.
Businesses usually have to file their 1099s with the IRS by February 16. If you’re cutting it close, you can ask for an extension. To do this, file Form 8809 online or fill it out and mail it. You can send the form to:
Department of the Treasury
Internal Revenue Service Center
Ogden, UT 84201-0209
You have until January 31 of the next calendar year to send out 1099s to your contractors. If you’re reported, sending these out late can carry penalties. But mistakes happen. If a contractor forgets to include income on their tax return, they can amend it by using Form 1040-X with the IRS. This form can be filed online or by mail. However, the address it needs to be sent to varies depending on the state where the business is located.
It’s important to note that the pandemic has thrown lots of things off their regular schedule. Check the IRS website for updates on extensions and other COVID-19 changes.
Self-Employment Tax Benefits of S Corporations
If you’ve been self-employed for a while, you know that taxes can be killer. Employees split the cost of their Federal Insurance Contributions Act (FICA) taxes with their employers, which equals 15.3% of the employee’s gross income. These taxes go toward Social Security and Medicare. However, rather than FICA taxes, you pay a self-employment tax, which requires you to fork over the entire 15.3% on 92.35% of your gross income.
There’s a way to limit your self-employment taxes, though. By registering to be taxed as an S corporation, you become both an employee and a shareholder in your business. You pay yourself a reasonable salary (as determined by the IRS), which is subject to FICA taxes. However, the rest of your business profits are considered dividends and are not subject to FICA. There are a few exceptions to this, which you can find on the IRS website.
To simplify things, we’ll only discuss FICA tax savings and leave out other taxes for now. Let’s say you’re a freelance copywriter who makes $60,000 a year. You’ll owe $8,477.73 in self-employment taxes at the end of the year.
($60,000 x 0.9235) x 0.153 = $8,477.73
Now, let’s tax you as an S corporation. You elect to pay yourself a salary of $40,000 a year. You’ll pay $6,120 in FICA taxes. That’s a savings of $2,357.73 for the tax year.
$40,000 x 0.153 = $6,120
Before you can file to be taxed as an S corporation, though, you must have formed an LLC or corporation. If you’re an LLC, you’ll also have to first file to pay taxes as a C corporation before applying for S corporation status.
Also note that, unlike a C corporation, an S corporation is still considered a pass-through entity, so you won’t be double-taxed.
There are a few possible negatives to filing as an S corporation. The process for filing to be an S corporation can be difficult and time-consuming. With an S corporation tax structure, you’ll attract more attention from the IRS. S corporations must adhere to more regulations than a standard LLC or C corporation.
Learn more about business formations
If you’re thinking about taking the next step with your business, hiring independent contractors can be a smart business decision. It can save your company time, money, and effort. When forming your own business, be sure to consider all entity options for tax impact. Depending on the nature and location of your business, having an S corporation can reduce your taxes. Still, there are disadvantages to every tax structure, and it’s always wise to seek the advice of a tax professional, like a certified public accountant (CPA) or an attorney before deciding.
Starting any business or taking it to the next level can be thrilling. Having to make so many important decisions can also be pretty scary. Let ZenBusiness help. We’ll guide you through things like forming an LLC, corporation, or S corporation, managing your invoicing and payments, and staying in compliance. Let us worry about the little things so that you can worry about the big ones.
Disclaimer: The content on this page is for informational purposes only, and does not constitute legal, tax, or accounting advice. If you have specific questions about any of these topics, seek the counsel of a licensed professional.