For tax purposes, independent contractors are considered self-employed. However, these self-employed workers may be confused about whether they’re deemed full-time employees or contractors, and this distinction is crucial for tax purposes, HR, and their employers.
Who Qualifies as an Independent Contractor?
As a rule, independent contractors are people who provide a service in which the payer only has control over the end result. The payer has no say over what will be done or how it will be done, unlike an employer who has the legal right to control their employees’ actions and performance.
Sometimes your employees may also take on contract work on the side. If that’s the case, they can use a W-2 template (for employment income) along with Form 1040 (for independent income) to ensure they’re paying the appropriate tax rate on both forms of income.
Why is Employee Classification Important?
Many businesses will hire freelancers because they’re less expensive, require less paperwork, and can easily fill short-term positions. For these reasons, employers may misclassify their employees as independent contractors, either by accident or on purpose.
Misclassification is a widespread problem that costs government agencies billions of dollars each year, but the repercussions on employers can be significant, even bankruptcy worthy.
Specifically, the company could be subject to a 1.5% penalty of the employee’s wages and up to 100% of the matching FICA taxes the employer was supposed to pay. That’s not to mention legal penalties and the blow to the companies and the CEO’s reputation.
How Can HR Help Contractors File Their Taxes?
It’s important that payroll has a grasp of who should be getting which tax documents, so both their employers and workers aren’t upsetting the IRS. After that, the HR department should:
- Request a Form W-9: Form W-9 collects your self-employed contractors’ Tax Identification number. It’s a one-page form that gives your employer the right to send over a Form 1099-NEC to the contractor and the IRS. Tell your independent contractors they don’t have to send a copy of a W-9 to the IRS, as you’ll do that for them.
- Explain Self-Employment Taxes: Self-employment taxes, or FICA taxes, consist of a contractor’s Social Security (12.4%) and Medicare tax (2.9%) for a total of 15.3%. They also have to pay income tax in their tax bracket. Since freelancers pay 25-35% on average, HR should coach their contractors to save 25-30% of their income for taxes.
- Take Advantage of Deductions: There are dozens of tax deductions freelancers can take advantage of to lower their tax burden. The IRS allows self-employed contractors to claim up to 50% of their income, so it’s possible to save thousands of dollars.
- Explain Form 1040 and Schedule C: Instead of Form W-2, independent contractors will use Form 1040 and Schedule C to calculate their profit and loss statement. The IRS needs this information to assess taxable income and non-taxable deductions. HR must tell contractors to send Form 1040 with a filled-out Schedule C to the IRS.
- Offer Advice on Separating Expenses: Freelancers can make tax filing easier by opening a separate checking account for their business expenses. They should also explain that tracking their expenses monthly is simpler than last-minute bookkeeping.
- Explain Form 1099-NEC: 1099-NEC replaced the 1099-MISC form in 2020 and accounts for most self-employment income. Contractors should receive one 1099-NEC for every client that requested more than $600 worth of work within a year. The employer must send a copy of the 1099-NEC to their contractors and the IRS by January 31st. Independent contractors do not have to send or fill out the 1099-NEC form, but they will need it to prove their income stated on Form 1040 to the IRS.
Finally, unless your independent contractors operate a highly profitable business (in which they file quarterly), their tax filing due date, which is April 15th in most cases, stays the same.
