Changes to tax law at the end of 2017 have created questions, concerns, and unique tax planning opportunities and challenges for many taxpayers. You can learn more about the tax law changes that had the most affect on our clients and tips for planning for next year in our blog post “Surprise Balance Due or Increased Refund? Here’s What You Should Know.”
One change that created the most surprise, and sometimes disappointment, among Levesque & Associates clients during the 2018 tax season was the loss of unreimbursed business expenses as a write-off. Prior to tax year 2018, W-2 employees who personally incurred business expenses (that went unreimbursed by their employer) could write-off those amounts on their annual tax return. This affected many taxpayers, but we saw significant impact on individuals who worked in outside sales. Many of these professionals incur significant expenses each year through travel, mileage, client gifts, client dinners, home office expenses and more. Write-offs topping $20k or $30k were not uncommon under the former tax law. Losing the ability to write-off these unreimbursed business expenses had significant financial impact on many taxpayers.
As a result of this change, many individuals have asked “what’s the benefit of W-2 over 1099?” It’s important to remember that these two employment classifications come with differences that are more significant than just income and write-offs. Keep reading for a list a few key items you should consider.
Before we dive into significant differences like tax treatment and employee benefits, it’s important that you understand the very basics of 1099 vs. W-2. In terms of tax treatment, individuals who receive 1099s are considered independent contractors. Those who receive a W-2 are considered employees. Employees have taxes withheld from each paycheck (federal and state income tax, medicare, social security, etc). Additionally, businesses with W-2 employees must also pay payroll taxes for each employee on a state and federal level. Businesses with contractors do not pay any payroll taxes and nothing is withheld from contractors’ paychecks. As a result, contractors should strongly consider making estimated payments throughout the year to avoid a sizable tax bill and penalties at tax time.
There are a few ways that employee vs. contractor is determined. It’s not as simple as individual or business preference. In other words, an employer cannot decide to make all employees contractors in order to avoid the responsibility of payroll taxes. A key to determining the classification is “control.” Independent contractors generally have more control over their own schedule, workload, work environment, etc. They also have the flexibility of working with multiple “employers” which are typically considered clients by contractors. Additionally, contractors generally are required to provide their own supplies and vehicle (if the job requires driving to meet clients or visiting job sites). Alternately, employees typically have set work hours and/or a schedule. Employees also have little control over their workload and instead are often given assignments. Employers also provide a work space and work supplies for their employees in most situations and even company vehicles in some cases.
In addition to the aforementioned need for making quarterly estimated payments, additional taxes will be calculated for contractors. Employees who receive a W-2 have 7.65% of their income withheld automatically for Social Security and Medicare taxes. Employers then match that percentage by also paying 7.65% per employee. If you are 1099’d then not only will you have to pay the 7.65% that employees pay, but you will also have to cover the additional 7.65% of the employer. That means you will be paying 15.3% of your income into Social Security and Medicare.
A tax benefit that came with the TCJA for independent contractors and business owners is the 20% pass-through deduction or Qualified Business Income (QBI) deduction. The deduction allows some taxpayers to deduct up to 20% of their qualified business income. According to the IRS:
“[Qualified business income] is the net amount of qualified items of income, gain, deduction and loss from any qualified trade or business, including income from partnerships, S corporations, sole proprietorships, and certain trusts. Generally this includes, but is not limited to, the deductible part of self-employment tax, self-employed health insurance, and deductions for contributions to qualified retirement plans (e.g. SEP, SIMPLE and qualified plan deductions).”
Contractors can write-off A LOT of the expenses incurred to perform their job(s). W-2 employees lost this ability under the TCJA. Examples of deductible expenses for contractors include:
- Home office
- A percentage of home utilities
- Vehicle maintenance
- Lease payments
- Client meals (entertainment is no longer deductible under the new tax law)
- Cell phone
With this long list of available write-offs, it is extremely important that contractors stay organized throughout the year. Whether QuickBooks, Excel or another accounting program is selected to track information, contractors must remember to retain receipts in case of an audit. Records should be kept for 7 years.
Employers often offer employee benefits such as retirement, health insurance, and life insurance. These perks are sometimes used to attract and retain top talent. Contractors, however, do not get these benefits. There are still ways to save for retirement while deferring some of your taxable income. Speak with your CPA or Financial Advisor for more information and for options that are right for you. If you don’t have a CPA or Financial Advisor, Levesque & Associates would be happy to assist you.
Contractor arrangements can be a huge win for businesses. Employers benefit from an employee without having to pay payroll taxes or offer retirement or health insurance benefits. They do, however, lose a great deal of the control that they would have over an employee so finding the right person or people can be a challenge. For the actual contractor, though, the arrangement can present challenges and surprisingly large tax bills. If you are a contractor or are considering becoming one, remember that organization is key! In addition to a knowledgeable CPA, there are a few resources that can help make tax time less stressful. Check out a few examples below:
- Keep track of your mileage each year with IRS compliant MileIQ
- Log receipts and expenses on your phone with Expensify
- QuickBooks Self Employed is an affordable and mobile-friendly platform for keeping your books up-to-date