McNew & Associates, Inc. Blog


1099 Independent Contractor or Employee – The Age-Old Question
February 24, 2012, 8:58 PM
Filed under: Uncategorized | Tags: , , , , , , , ,

Year after year this question comes up, both in end of year tax reporting functions and during proposal pricing and contract performance.  It goes without saying that many times personnel are often mis-classified, mainly because the payer doesn’t know the specific rules governing what constitutes an employee versus a 1099 Independent Contractor, all for the purpose of getting “cheaper” labor since the payer does not have to pay payroll taxes for the labor (FICA, FUTA, SUTA, etc.).  In this highly competitive area (Lowest Price Technically Acceptable) of Government contracting, contractors are looking for as many ways as possible to reduce their overall price to the government, and many resort to the 1099 concept, without understanding the repercussions for improperly classifying personnel by the IRS.

So who qualifies as a 1099 Independent Contractor?  The IRS defines Independent Contractors as being people such as doctors, dentists, veterinarians, lawyers, accountants, contractors, subcontractors, public stenographers, or auctioneers who are in an independent trade, business, or profession in which they offer their services to the general public.  The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done.  The earnings of a person who is working as an independent contractor are subject to Self-Employment Tax.  You are not an independent contractor if you perform services that can be controlled by an employer (what will be done and how it will be done). This applies even if you are given freedom of action. What matters is that the employer has the legal right to control the details of how the services are performed.

Deciding who is an independent contractor falls under 3 Common Law Rule categories that should be weighed when making the determination (IRS Form SS-8 Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding provides a full breakdown of questions):

Behavior:  Does the payer have control, or right to control, what the worker does or how the work gets completed?

Financial:  Are business elements of the worker’s job under the payer’s control?  This includes how the person is paid, whether expenses are reimbursed, and who provides the tools/equipment required to get the job done, among other variables.

Relationship:  Does the person have a written contract in place with the payer?  Does the person receive benefits from the payer, including payment for holidays?  Will the work continue long term and is the work a key element of your business.

Of course there are no specific answers to the above that definitively determine whether the person is an employee or a 1099 Independent Contractor, but it is safe to say that answering yes to most of the few questions listed above qualifies the person as an employee, and therefore, taxes should be withheld as you would any other employee.

So how exactly does this affect you, the contractor?  Well, most companies who have operated using what they classified as independent contractors, who do not technically meet the definition of an independent contractor as defined by the IRS so as to keep costs low, may find themselves on the bad end of a Defense Contract Audit Agency (DCAA) audit once DCAA get’s its incurred cost audits back up to date.  Currently DCAA’s 2012 agenda is to get incurred cost submissions caught up through 2007 by the end of FY 2012.  As DCAA begins catching up on these audits, one of the focus areas will be subcontractor and independent contractor costs.  If DCAA determines that subcontractors and independent contractors have been mis-classified by the contractor, not only could those costs potentially be questioned (disallowed), but it will be DCAA’s responsibility to notify other appropriate government agencies (i.e. IRS and SBA) of the mis-classification.  This will come with potential repayment of unpaid payroll taxes (FICA, FUTA, SUTA) by the contractor for the wages paid.

In the end, it is your responsibility as a government contractor to ensure that you are appropriately classifying personnel.  Don’t get caught up trying to cut costs in your pricing by using ICs who are not appropriately classified…it could come back to bite you.

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