For part-time or consulting work, how are you classified by your employer: as a consultant or as an employee?
Since we’re primarily talking about taxes in this post, the difference is that an employee receives a “W2” and the consultant receives a “1099” each year from their employer. These forms — provided to you and the IRS — document how much you earned in a given tax year. The type of form you receive is important because the tax treatment of W2 income and 1099 is very different.
Hiring you as a consultant instead of as an employee, your employer saves a lot of money in taxes. The biggest is Social Security tax — employers are required to pay the SSA 6.2% of your salary below $97,500. Medicare tax adds on an additional 1.45% of your pay. And don’t forget about unemployment, disability and other taxes which your employer pays on your behalf.
When you get paid as an employee, you pay the other half of your “payroll taxes”: 6.2% of your wages for Social Security, and 1.45% for Medicare. If you incur any job-related expenses which you don’t get reimbursed for, you can deduct them on your taxes. But there’s a catch: your unreimbursed-job-expenses are not an “adjustment” to your income. Instead, they are considered a “miscellaneous itemized deduction”, and only reduce your taxes to the extent expenses in this category exceed 2% of your Adjusted Gross Income (line 37 on your 1040).
If you work as a consultant, the tax treatment is very different. You — and the IRS — will receive form 1099-misc from your “client” (not employer). Items on the 1099-misc are considered “self-employment income” and you still have to pay 15.3% of your pay in Social Security and Medicare taxes. Just as 1/2 of this amount is deductible by your employer when you are an employee, you are allowed to deduct 1/2 as an adjustment to income. Here’s where the real difference comes in: unreimbursed-job-expenses are netted against your consulting income. This can result in a substantial reduction in taxable income for many people. Not surprisingly, the IRS would MUCH prefer companies to pay their workers as employees and not consultants.
The reason I’m writing about this topic now is that the IRS recently reached an important agreement with a soccer league in Connecticut regarding their treatment of coaches. Excerpt from $NYT article:
In a case widely watched by youth sports leagues across the country, the Internal Revenue Service has reached an agreement with the Fairfield United Soccer Association that clarifies the employment status of the group’s coaches, the association’s president said yesterday.
Under the agreement, the Fairfield, Conn., league will begin in 2008 to treat about half of its 30 coaches — those not employed by professional coaching associat ions — as employees rather than as independent contractors, and will withhold taxes from their pay. And the league will pay $11,600 in back taxes, according to Jay Skelton, the group’s president, a fraction of the $334,441 in taxes and fines the I.R.S. had assessed it in 2004.
“We said we tried to comply with the rules, and we thought we were, but we made mistakes, so we agreed to pay the tax due,” Mr. Skelton said. “For 20 years all of these coaches have been reported as 1099 employees for everybody. If you talk to 100 clubs, I guarantee almost every one, if not all, would declare these guys as independent contractors.”
It was not the first time the I.R.S. had fined a nonprofit youth sports league, but the proposed penalty was one of the largest, sending worried sports officials in Connecticut and other states scrambling to review the tax code. Mr. Skelton said that over the last two years, about 200 people involved in youth sports had contacted him asking about the resolution of the case. He said the assessment had threatened to put the Fairfield association out of business. (NYT)
The IRS wants the league to treat coaches as employees because the government will receive way more revenue that way. Here’s a simple example to illustrate:
Coaches are considered “consultants” and issued 1099’s:
Let’s say a coach earns $1,000 in a year. The coach can easily cook up $500 of expenses related to the coaching job — transportation, equipment, gifts, etc. The result is net self employment income of $500. This $500 is the amount which social security, medicare, & income taxes are based.
Coaches are considered “employees” and issued W2’s:
Keeping with our above-mentioned example, let’s say the coach earned a salary of $1,000 in a year. First, the employer & the employee would pay a total of 15.3% of the salary in payroll taxes. Second, the $1,000 salary would flow directly to the coach as “ordinary income”. The $500 in job-related expenses are not allowed to be netted against this income. It is quite possible that the coach will not be able to deduct the $500 because he or she probably won’t have miscellaneous expenses (including unreimbursed-job-expenses such as these) which exceed 2% of AGI.
Bottom Line: How you are classified — employee or consultant — makes a big difference for both you and your employer come tax season. Since the government wants you to be an employee (and not a consultant), it could become a little more difficult to keep your status as a consultant. Fortunately, there are some steps you can take to ensure that you keep your consultant status. I’ll try to post about that topic soon.