W2 VS 1099 FOR BEATING TAXES

Every time you provide a good or service to another person or business you need to decide your what your relationship with them will be from a tax perspective. Especially as the culture of work changes and people decide to start their own small business in the gig economy or work for a single employer.

And in tax land the most common types of work relationships for someone providing a good or service is to be either a “W2” or a “1099.” Here’s what those terms mean and where they came from.

W2

W2 comes from the tax form “Form W2”, and is the tax form that an employee receives at year-end from an employer they worked for. We call it a W2 for short.

The Form W2 includes data like how much money you earned, how much federal income taxes were withheld from your paycheck throughout the year, how much you contributed to your retirement account, and other paycheck related data. Most people that receive a W2 worked for a singe employer at a time, were on a traditional 40 hour work week structure, and fit the traditional model of employment.

1099

1099 comes from the tax form “Form 1099." At the beginning of the year, businesses send out a 1099 to an independent contractor who provided goods or services throughout the year. We call it a 1099 for short.

The term 1099 and independent contractor are interchangeable; independent contractors receive a Form 1099 at the end of the year, and it’s common to hear business owners say “we have 5 1099’s working with us”, meaning they have 5 independent contractors providing goods or services to the business.

When independent contractors receive a Form 1099 at year end the form will report the compensation that the business paid to the independent contractor. These forms are also reported to the government. Once these forms are submitted, the independent contractor’s income is now visible to the government. The independent contractor is then responsible for paying his own payroll and income taxes.

These two terms are so important to be aware of because they can create MASSIVE differences in a business owner’s taxes owed to the government, how vulnerable they are to lawsuits from people providing labor for their business, and the dynamic a business owner establishes with their staff.

When I meet with business owners to create custom tax plans and help them pay little to no taxes, discussions about 1099’s vs W2’s and their workforce come up often. If you’ve ever wondered whether it’s better to have 1099’s or W2 employees on staff, here’s my take:

Always opt for 1099’s, for a few reasons.

One, 1099’s are significantly cheaper for the business owner when it comes to taxes. The business owner isn’t responsible for withholding, submitting, or covering half of the independent contractor’s payroll taxes to the federal and state governments. When we say the term payroll taxes, we mean Social Security and Medicare taxes.

Social Security steals a 12.4% tax on all wages paid in the United States up to $160,200 per year. Think about that for a moment. Every single dollar that trades hands between a business owner and an employee loses 12.4% to the government to pay for the retirement of people you’ve never met on the other side of the country. On top of that, Medicare steals a 2.9% tax on all wages paid in the United States, with no limit or ceiling. So between Social Security and Medicare, roughly 15.3% of wages in the US are stolen to pay for socialist government programs.

If you’re a business owner with W2 employees, the common business practice is to withhold half of these taxes on behalf of your employees in a bank account and submit them either bi-weekly or quarterly to the government. And, few people know this, but business owners typically cover half of the liability for the employees. So employees will usually have about 7.7% of their wages taken out of their paycheck and coming out of their net deposit. And business owners cover the other 7.7% with their own dollars.

So as a business owner: if you cut a check to a W2 employee for $10,000, $1530 of it is going to Social Security and Medicare. The employee will lose about $770 of it to Social Security and Medicare taxes, meaning they’ll cover half the burden. And then you will be expected to pay the other $770. So when you cut a check for $10,000 to an employee, you’ll actually be paying closer to $11,000 when you cover their share of payroll taxes.

The taxes don’t stop there. Don’t forget about state disability taxes, depending on the state you live in. California employers know all too well what I’m talking about. Or, most commonly across many states, SUI taxes. SUI stands for State Unemployment Insurance. As businesses grow and bring on employees, they have to pay taxes on their payroll to the state where their employees are located to cover the state’s unemployment fund for employees. The more employees a business has, the more likely they are to have employees that get laid off and file unemployment claims against the business. The more often this happens, the worse the employer’s ‘unemployment rating’ becomes with the state, and the higher SUI tax rate they have to pay on employee wages. It’s a vicious cycle for business owners; the bigger you grow, the more employees you typically hire, the more in taxes you have to pay. The punishment of success.

The second reason to opt for 1099’s on the workforce is that it creates a better dynamic between the business and the person providing goods or services. When a business hires a W2 employee, they’re establishing a thinly veiled slave/owner dynamic. The employee submits to the business owner, agrees not to work for anyone else and signals they will become dependent on the income the business owner offers them, the employee agrees to give up a portion of their pride and dignity by asking for “time off” to go enjoy life outside of work, etc. I suppose this dynamic is handy if you’re the business owner and want a force of dedicated helpers.

However, these dedicated helpers don’t bring critical characteristics to the table. They’re not running their own business and creating their own income, so they’re not hungry to perform or grow their brand like an independent contractor is. Employees usually want to do the bare minimum to guarantee a paycheck every two weeks. When you hire an independent contractor, you’re partnering with someone who knows that at any second they can leave the engagement with you, and they know that at any second you can decide you don’t want their services anymore. It’s a relationship that is well aware of how finite it can be. Both parties work extra hard to take care of each other and provide a great experience because they know it can end at any time.

Finally, the third reason why I recommend business owners hire a 1099 instead of a W2 employee is the liability. Employment law varies by every state and federal employment law is a complicated beast that’s been growing for decades. But suffice it to say that regardless of where you live or work, there is a mountain of employment law that typically favors the employee and not the business owner in case a professional relationship ever goes sideways. Employees are much more likely to sue an employer for breach of contract, lost wages, misclassification, violation of discrimination legislation, etc. Every time a business owner hires an employee they are risking that employee filing a claim for worker’s compensation, unemployment, or a bunch of other lawsuits. In short, employees = shadow liability. It’s just a matter of time before one gets upset and gets committed to ruining your career.

As a good example of this mountain of employment law and the overly litigious society we live in, here’s my obligatory disclaimer. I’m not an employment law attorney and you should consult yours about employment classification and who you can legally pay as an independent contractor vs an employee. As a hint, and more unsolicited advice, always try to structure the relationship so you pay your staff as independent contractors

Tax hacks are built over time. Inches add up to miles and hundreds of dollars saved quickly add up to thousands of dollars saved.