Ledger Aid Blog

Determining the Difference Between W2 and 1099. AND WHY IT MATTERS.

The IRS is constantly conducting payroll audits for misclassification of workers. It is a very common mistake that small business owners make, but one that comes with a very heavy fine if an auditor decides to find an owner guilty of doing so. Small businesses are easy targets because most lack an HR department to ensure that employee files are dealt with correctly. Most small business owners would rather believe that if the IRS hasn’t knocked on their door by now, they probably aren’t coming. They are wrong.

I started working with a client right around the time that she received her audit notice last year. She confessed to me that she had been classifying everyone working for her as a 1099 for years! By the time she realized it, putting these misclassified workers on payroll, as employees should be, would have been more expensive than what she could realistically afford. My client had grown her business saving over 35% on labor costs and now she had workers she could not legally afford. She thought that because she paid these workers anyway, what she was doing was really harmless. But the IRS takes this matter very seriously so it’s important for you to always know when a worker is considered an independent contractor (1099) or an employee (W-2), and the proper procedure that each one requires.

If your intentions are to do things right but the lines between employee and independent contractor seem to blur all too easily, I’ve put together 4 fool proof ways to help you determine if your worker should be receiving a 1099 or a W-2 at the end of the tax year.

1. Work hours: This can be one of the easiest ways to know right off the bat. If you tell your worker at what time they must report to the office or be out on the field and how long you expect them to be there, they are 100 % an employee.

2. Tools and supplies: Are you providing all of the supplies and materials for your worker to perform the tasks agreed? They are 100% an employee.

3. Payment terms: Do you receive an invoice from your worker or are they clocking in to the time tracker monitored by your office? If your worker is invoicing you, they are 100% an independent contractor. If you are paying your worker based off their weekly time sheet generated by you or any of your company’s applications, then they are 100% an employee.

4. Availability: Is your worker free to provide similar services to other companies while they are providing their services to you at the same time? If there is no conflict of interest there, then that worker is 100% an independent contractor.
It’s important to always classify your workers correctly. If you have been consistently doing so, keep records of all contracts and hire forms in case you have to dispute an audit.


What to expect when audited:
When you receive an audit notification, you will be notified for which period they are choosing to audit you. It is in your best interest to send as much information of the two pages of information requested by the IRS. The funny thing is that when you are audited for misclassification of workers they request everything from your balance sheet, to your cash flow statement, even stub payment copies for that period. Most of the information that will be requested by your auditor can actually be printed straight from your accounting software, so here is where the importance of keeping clean books comes in as well.

The earlier you do things right, the better. But if you are already in the middle of an audit, speak with your accountant and develop the best way to proceed. They will know if there is any possibility of fees being reduced and they can give you an idea of how serious your case is. However, in the end it is up to your auditor to decide whether or not to fine you to the full extent. Some auditors just intend to “educate” you and fine you less than the required amount with the agreement that you will attend an additional meeting.

If you find yourself in the middle of an audit and require help reviewing your notice letter, feel free to contact us any time.

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