Maybe not 1099 reasons. But there are good reasons to go the independent contractor route versus hiring employees. Of course, there are also compelling reasons to go the other direction on that. There’s a lot to consider when you make this choice, so let’s dive in.
Independent Contractors Versus W2 Employees
Before we get into the reasons to hire independent contractors, we need to understand the essential differences between the two, especially from the point of view of the IRS. Straight from IRS.gov, an independent contract is “an individual is an independent contractor if the payer has the right to control or direct only the result of the work, not what will be done and how it will be done.” With a W2 employee, the business must pay income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax. There are also insurance costs involved. With a 1099 contractor, the business simply pays contracted rates, and the contractor pays all associated taxes. It’s obviously important to get this right, as the business may face penalties, fines, legal fees and even an audit otherwise.
Pros and Cons of Hiring Independent Contractors
Depending on the business model, there are several advantages and disadvantages to hiring a contractor versus an employee.
Pros of Hiring Independent Contractors:
- Cost Savings: The cost ‘burden’ of employees in terms of taxes, withholdings, benefits, etc.
- Flexibility: The business can directly match hiring with the required workload and not have extra or too few staff on hand.
- Mitigate Legal Risks: The business transfers legal risks to the contractors.
- Reduce Turnover Costs: Every time an employee quits, the business has the time and money expense of conducting a search, hiring the new employee and getting them trained up. With an independent contractor, it’s, “Next!”
Cons of Hiring Independent Contractors:
- Risk of Audits: Both federal and state governments have a keen eye on the use of independent contractors. Just look at the rift with Lyft and Uber
- Less Control: By definition, the business has less control over a contractor’s work than an employee.
- Consistency: With different contractors (and their own workers) on your projects, the work and even end results may vary.
- Scheduling: With less control also comes the task of scheduling contractors, who are working for multiple clients. This can cause scheduling delays and even cost overruns.
Hiring and Paying Independent Contractors
When it comes to hiring an independent contractor, there is only one required form: the W9. The W9 basically gives you the contractor’s information for tax filing purposes, and you’ll use this information to complete the 1099-MISC at the end of the tax year. That’s the required piece. In addition to that, you need to consider these additional documents:
- A Contract: After all, they’re called ‘contractors’ for a reason. A contract will set expectations and a baseline for the work and the pay.
- Insurance: Depending on the type of work involved, you may also need an insurance certificate from the contractor’s insurance company demonstrating the necessary coverage for your project.
- Invoices: You need to get invoices from your contractors so that you can account for the expenses properly. These become extremely important should an audit occur.
How to Reduce the Tax Risk of Using Independent Contractors
Now that you’ve hired your contractors and kept good records, you need to focus on minimizing your taxes and realizing the true financial benefits of hiring an independent contractor versus and employee. You’ve already avoided the costs of income and unemployment taxes. After that, the tax effects of an independent contract come into play with your accounting. Make sure you account for the labor and contract costs in each project to reduce your overall Gross Profit. Also, if you hire any independent contractors to work in your day-to-day business, not associated with any projects, make sure you account for those expenses as well. Again, gathering records, such as invoices, checks, and bank transactions is key.
Still Not Sure?
Hiring independent contractors versus employees is an important—and nerve wracking—decision that holds serious implications for both cash flows and taxes. The ability to expand and contract your workforce may outweigh the issues with potential scheduling and work consistency. If that’s the case, work with your accountant to ensure that you’re compliant, keeping tight records, and filing the necessary forms.
Have a question? Contact William Rogers.
Author: William Rogers, MBA, CFP, EA is the founder of Ascend Business Advisory, a boutique tax and financial advisory firm in San Diego, CA. He has a BS in Business Management from the University of Redlands, an MBA from the University of Southern California, and an MS in Finance from Golden Gate University. His practice specializes in serving the needs of entrepreneurial start up companies.