Business is changing all the time. As the economy recovers, many companies are growing faster and stronger than their owners expected. To handle increased workload, orders or numbers of clients, many are turning to contractors or outside vendors for help. Tax regulations in this area have changed in the past several years as the IRS tries to close the tax gap created by unreported or under-reported taxes by small to mid-size businesses. It's important to ensure your business is in compliance to avoid unwanted attention from the IRS.
Overview of the 1099
IRS Form 1099 reports to the Federal government various types of taxable income paid to contractors and vendors. There are versions of the 1099 to report payments for services as well as interest, dividends, and real estate sale proceeds. The form is issued by companies to freelance workers, contractors and vendors including medical care providers and attorneys (even if they are incorporated) who provide services in excess of $600. Companies generally don't withhold taxes (see below for the "backup withholding" exception) from the payments to these workers. To ensure that companies and workers properly report earnings, the IRS has added questions to corporate, partnership and individual tax forms in recent years to identify taxpayers who should be filing forms 1099. For-profit and nonprofit organizations must file 1099s, as well as sole proprietorships, partnerships and corporations. To ensure you are in compliance as an employer, a best practice is to require all vendors to complete a W9 upon engagement or before they are able to receive payment.
Exceptions to 1099 Filing Requirements
There are some exceptions to what type of payment must be reported. Payments made by cash, check, wire transfer, electronic check, ACH, online bill pay (bank to bank only), or direct deposit are required to be reported, but payments to vendors using credit cards, debit cards, gift cards, or any other third-party payment network (such as PayPal) should not be included. Processing companies like PayPal, for example, are responsible for reporting those payments on a separate version of the 1099 form (1099-K).
In some cases, "backup withholding" is required, as when the service provider or vendor does not provide a Taxpayer Identification Number to the employer. In those cases, the employer is generally required to remove "backup withholdings" (currently 28%) from any payments due the worker or service provider, and remit these amounts to the IRS. Backup withholding is required on all payments until the business receives the payee's identification information. If there is backup withholding, a 1099 must be issued even if the amount paid to the recipient is below the filing threshold. Penalties for not withholding are equal to the amount that should have been withheld—28% of the gross payment to each worker.
What Happens if You Don't File Correctly?
So what happens to companies or employers that don't comply with the 1099 filing requirements? There are several types of penalties for failure to file 1099 with the IRS, intentionally filing incorrectly and failure to provide copies of 1099s to recipients. The penalty types are not mutually exclusive, which means that if you fail to file 1099s with both the IRS and the recipient, the penalties could be double the standard penalty rates.
The penalty for failure to file, which is based on when you file, ranges from $30 to $100 per form, with a maximum penalty of $1.5 million per year. This is a significant increase from the previous maximum penalty of $75,000 to $250,000 per year ($25,000 to $100,000 for small businesses). The penalty for intentional failure to file or intentionally filing incorrect information is $250 per form with no maximum.
Best Practices Provide the Best Protection
The best way to ensure you are in compliance is to follow these best practices. First, make sure you are correctly classifying your workers. Independent contractors, those that should receive 1099s, are skilled and qualified experts who perform services without being subject to control over the manner and means in which services are performed. Employees are typically more closely managed, have designated hours, report to designated work sites and have more defined job responsibilities. There are various federal and state tests that can help you determine which status is correct.
Next, establish a standard process for executing contracts with and obtaining Form W-9 from all vendors, contractors and service providers to make the reporting process more efficient. It will ensure you have the correct information for preparing a 1099 and will protect you against the requirement to withhold income tax from vendors who do not provide this information to your organization. Maintaining documentation that supports your worker classification will help if you are ever audited.
Finally, read and make sure you understand the 1099 reporting requirements, or make sure your accountant is well-versed in them. Experienced accountants stay up-to-date on the changing regulations and the precedent-setting case law that can make 1099 compliance difficult to achieve.
For more information about this article, or to discuss your company's employee classification and tax reporting, please contact Laura E. Speir, Business Accounting Manager.