By Paul S. Hamann & Jack Salewski, CPA, CGMA
1099 or W-2? That’s the number one question Jack receives here at RCReports.
We hear your argument: Paying wages via 1099-MISC instead of W-2 has no tax effect!
Here’s Jack’s reply: It’s the law.
FS-2008-25 states: Corporate officers are specifically included within the definition of employee for FICA (Federal Insurance Contributions Act), FUTA (Federal Unemployment Tax Act) and federal income tax withholding under the Internal Revenue Code.
Generally, an officer of a corporation is an employee of the corporation. The fact that an officer is also a shareholder does not change the requirement that payments to the corporate officer be treated as wages.
Just to be certain we looked up the IRS definition of Employee and Independent Contractor, just to make sure there wasn’t some loophole or wiggle room to argue for independent contractor status.
Employee: Under common-law rules, anyone who performs services for you is your employee if you can control what will be done and how it will be done. This is so even when you give the employee freedom of action. What matters is that you have the right to control how the services are performed.
Independent Contractor: 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.
What this means to your bottom line:
The IRS takes this issue very seriously and does not hesitate to assess hefty interest and penalties to folks who don’t comply. The IRS will reclassify all 1099-MISC payments made to S Corp owners as W-2 wages. This means that there are several months, sometimes even years of payroll taxes that the S Corp will now have to pay including the following:
- Back taxes for payroll taxes;
- Interest on payroll taxes;
- Penalties for failure to file quarterly Forms 941;
- Penalties for failure to timely pay the tax withholding to the IRS;
- Penalties for failure to file and issue Form(s) W-2;
- PLUS Back taxes for state and local payroll filings, interest, and penalties.
What about real estate agents? Of course, they are independent contractors!
Jack says: Sometimes.
It is a fact that real estate agents can be paid via a 1099 for the work they do as a real estate agent. An agent paid for doing tasks other than selling real estate must have wages for those tasks reported on a W-2. There are two options here:
- Issue a 1099 for real estate services and issue a W-2 for all other services, or
- Put all compensation on a W-2.
Since it would be more efficient to put everything on a W-2, put all compensation on the W-2.
Here at RCReports we have seen as many, if not more, taxpayers get caught up in an IRS Reasonable Compensation challenge that was initiated at the state level. States generally have more at stake when it comes to Unemployment tax and some states are aggressively going after that revenue. When the state successfully forces the taxpayer to re-categorize 1099-MISC payments as W-2 wages the audit train begins rolling – next stop the Internal Revenue Service. And over the last two years Reasonable Compensation challenges initiated by the IRS have been coming mostly as a result of payroll audits. The examination begins by looking at 1099 contractors, but be advised, examiners are trained on Reasonable Compensation, so a simple request on how the S Corp owner determined his/her salary escalates easily into a Reasonable Compensation challenge.
Now, back to the original argument: Paying wages via 1099-MISC instead of W-2 has no tax effect! So why does anybody care?
Generally, the tax is the same, if you’re considering only FICA taxes, but not always. There are a couple of key situations to consider:
- If the shareholder/ employee has another W-2 and now the shareholder’s total wages are over the social security maximum, then the Federal Government is not getting the extra employee portion of the Social Security over the maximum.
- Starting in 2018 the amount that is on the 1099 which will be reported on the shareholder’s Schedule C now will have the 199A deduction applied to it. You may be able to override the tax software to show that this 1099 income is not “Qualified Business Income. However, other government entities, both state and local, also want their slice of the pie.
Now, assuming the shareholder will in fact pay the same amount of taxes via 1099 as by W2, there may be some scenarios where it may make more sense to beg for forgiveness than to comply.
Let’s say a client comes in after year end and after the filing deadline to file payroll tax returns. In a case like this if you file the payroll reports late there are going to be lots of penalties. This is a case to file a 1099 for the shareholder. The shareholder will then pick up the income on the individual tax return as Schedule C income, subject to self employment tax. There may be a penalty for late filing of the 1099, however, that will be less than the penalty for late filing and late payment of payroll tax returns. It is important that the taxpayer at this point starts to do payroll correctly. Most IRS agents will see that the taxpayer is trying to be compliant and will be reasonable.
In sum, report income on the correct form. If you’ve been reporting shareholder-employee income on a 1099, take a careful look at your practice and make a belated New Years Resolution to file the correct form going forward.