Introducing: Ask OOTB!
We get asked a lot of questions about payroll and all things related to payroll, both by people who are hiring and people who are getting paid. The production world has frequently relied on hiring a wide range of people as independent contractors, so it’s understandable that there are many questions and areas of confusion.
In an effort to contribute some clarity to the conversation, we are sharing some of the most commonly asked questions that OOTB receives, along with the relevant information that can help you better understand all things payroll. This will be an ongoing series, so if you have a question that you would like us to tackle, please submit it to us here.
In this first installment, we’ll be tackling the following questions:
Question #1: If an independent contractor has an S-Corp or an LLC and carries their own workers’ compensation policy, why do I have to payroll them? Isn’t the liability minimal for me if they have both of those things in place?
Question #2: What are some of the tax implications of being a W-2 employee, as opposed to a 1099-compensated independent contractor?
Please note: The information provided in this article does not, and is not intended to, constitute legal, tax, or financial advice. All information, content, and materials available in this article are for general informational purposes only. Information in this article may not constitute the most up-to-date legal or other information. We highly recommend that you seek the advice of an attorney or tax professional rather than relying solely on the information provided herein.
Question #1: Independent Contractors, S-Corps, & LLCs:
If an independent contractor has an S-Corp or an LLC and carries their own workers’ compensation policy, why do I have to payroll them? Isn’t the liability minimal for me if they have both of those things in place?
The determination of whether someone should be a payrolled W-2 employee or an independent contractor is based more on what that person does for your business than on whether they have their own entity. Courts and government agencies will look to the ABC Test, not whether an individual has an S-Corp or LLC, when making determinations on worker classification.
Even if an independent contractor has their own workers’ compensation insurance, there may still be lurking liabilities. Their insurance carrier could deny coverage if the independent contractor isn’t properly paying themselves a W-2 wage, or if they don’t have proper ownership coverages, in which case you could be deemed a “special employer” for workers’ compensation liability purposes.
In an Employment Development Department (EDD) audit, you could be assessed a penalty if the EDD finds that you misclassified workers as independent contractors. This penalty would be in addition to what you should have paid in workers’ compensation premiums.
An EDD audit occurs when the California EDD launches an investigation into a business's California state payroll tax records to determine if the business has classified a worker as an independent contractor instead of an employee.
The EDD can decide to audit if a worker makes the case that he or she is an employee rather than an independent contractor (typically when the employee tries to apply for unemployment insurance). Other triggers for an audit include: filing or paying late.
It is important to note that failure to obtain workers’ compensation insurance can also be deemed a criminal offense.
Question #2: Taxes & W-2 Employees
What are some of the tax implications of being a W-2 employee, as opposed to a 1099-compensated independent contractor?
It is important for workers to fully understand the realities of how W-2 and 1099 compensation differ.
Business Expenses
1099 contractors can potentially reduce their taxable income with qualifying business expenditures, but there are other increased tax liabilities, including the responsibility to pay the entire 15.3% SECA tax (also referred to as self-employment tax). Qualified expenses include costs associated with the operation of the business including home office, transportation, equipment for executing business, etc. It is important to note that home office and transportation expenses are limited, highly regulated, and frequently audited.
FICA Tax
W-2 employees pay a 6.2% Social Security tax and a 1.45% Medicare tax on their earnings, for a total of 7.65% of FICA (Federal Insurance Contributions Act) tax. These taxes are withheld from their paychecks and remitted to the IRS by their employer. Employers of W-2 employees match this 7.65% tax, for a total FICA tax contribution of 15.3% on earnings up to $142,800.
1099 contractors are responsible for paying both portions of the total 15.3% (both the employee and employer share) as Self-Employed Contributions Act (SECA) taxes, which translates to a potential 7.65% reduction in take-home pay.
Liability
Some people believe that having S-Corp status gives you the ability to manipulate the amount you pay yourself as W-2 income versus the amount you keep in the corporation. By reducing their W-2 income, they aim to reduce the total payroll taxes they owe. However, by doing this, they often risk workers’ compensation coverage denial and IRS or EDD audits that allow tax agencies to challenge deductions and apply both penalties and interest.