Bootstrapping entrepreneurs hire employees only when absolutely necessary. They hire to alleviate significant pain, not because they might need the employee in the future. Building a team of great employees is key to building a successful business. Every leader knows that. However, taking on the cost and commitment of employees too early can hold back and even kill that success.
To lessen the risk of hiring too many, too soon, most entrepreneurs start with contractors. A startup entrepreneur wouldn’t hire a full-time accountant or an in-house lawyer.
Contractors can be anything from a freelancer with a specialized skill, such as a graphic designer, to a large businesses that provides certain services, such as a law firm.
Hiring contractors allows you to avoid many of the costs and complexities of hiring employees. You don’t have to follow labor laws intended for employees, register for payroll accounts with state tax agencies, or pay employer payroll taxes.
However, hiring contractors still comes with tax-related consequences. This post is for a United States audience, but other countries might have similar requirements.
First, you must be careful not to classify someone as a contractor when they should be an employee. The IRS doesn’t like that. They will charge you for the payroll tax you should have paid (plus penalties and interest). But that’s a subject for another post.
In this post, I want to make sure you are aware of another tax risk with contractors.
Did you know that if you don’t handle payments to contractors correctly, you may have to send the IRS 28% of whatever you paid the contractor (on top of what you already paid them)?
The IRS wants their (our) money
Here’s the deal: the IRS has a harder time collecting tax from contractors than employees.
Employees have tax withheld from every paycheck. In most cases these withholdings are more than what the employee owes, which is why most people get a tax refund each year.
The IRS doesn’t have that luxury with contractors, so they came up with a system that increases the likelihood that contractors will report and pay taxes on their income.
What is the 1099-MISC form?
The system revolves around the 1099-MISC form and specifically Box 7 of that form, Non-employee compensation.
You must send to employees and file with the IRS W2 forms after the end of each year. Most business owners don’t need to think much about this because payroll service companies handle it all.
Similarly, you must send to certain contractors and file with the IRS the 1099-MISC form. Usually, this process is a little messier than payroll.
Not every contractor needs a 1099-MISC, and most businesses don’t pay all contractors in the same way. Some might be given checks, some might be paid through the payroll system, and some might be paid by credit card.
Issuing 1099-MISC should be an easy process if properly planned for, and the consequences for not doing so are severe. If the IRS finds that a contractor didn’t report and pay tax on your payments, you will be responsible for 28% of what you paid them (plus penalties and interest) to compensate for the lost tax revenue. Good luck collecting this from your contractor.
In my next post, I will go into more detail about who to issue 1099-MISC forms to, how to file, and what the W9 form has to do with it.