A hiring firm’s work is never done. Even after an IC’s services end, there is paperwork to complete. Failing to do so may mean severe penalties if you’re audited.
IRS Form 1099
The single most important thing to do after an unincorporated IC’s services end is to provide the worker and IRS with an IRS Form 1099-MISC reporting the compensation you paid the worker. Your failure to do so will result in severe penalties if the IRS later audits you and determines you misclassified the worker:
you’ll be required to pay the IRS twice as much for the misclassification.
you’ll lose the right to Safe Harbor protection for any payments not reported on Form 1099; this means you’ll lose one of your most valuable legal rights in defending against the IRS.
the IRS may impose a $100 fine for each Form 1099 you failed to file.
a. When Form 1099 must be filed
The basic rule is that you must file a Form 1099 whenever you pay an unincorporated IC—that is, an IC who is a sole proprietor or member of a partnership or limited liability company—$600 or more in a year for work done in the course of your trade or business.
EXAMPLE: The Acme Widget Company hires Thomas to install a new computer system. Acme classifies Thomas as an IC and pays him $2,000 during 2003. Thomas is a sole proprietor. Since Acme paid him more than $599, it must file a Form 1099 with the IRS reporting the payment.
In calculating whether the payments made to an IC total $600 or more during a year, you must include payments for parts or materials used by the IC in performing the services.
EXAMPLE: The Old Reliable Insurance Company pays $1,000 to an unincorporated auto repair shop to repair one of its insured’s cars. The repair contract states that $300 is for labor and $700 is for parts. Old Reliable must report the entire $1,000 on Form 1099 because the parts were used by the repair shop to perform the car repair services.
b. Services in the course of your trade or business
You only need to file a Form 1099 when an IC performs services that are in the course of your trade or business. A trade or business is an activity carried on for gain or profit. You don’t have to file a Form 1099 for payments for non-business related services. This includes payments you make to ICs for personal or household service—for example, payments to babysitters, gardeners and housekeepers. Running your home is not a profit-making activity.
EXAMPLE 1: Eddy owns several homes he rents out to tenants. He is in the business of renting houses. Eddy pays Linda, who operates a painting business as a sole proprietor, $1,750 to paint one of his rental houses. Eddy must report the $1,750 payment to Linda on Form 1099.
EXAMPLE 2: Eddy pays Linda $1,750 to paint his own home. He lives in this home with his wife and family and it is not a part of his home rental business. Eddy need not report this payment on Form 1099 because this work was not done in the course of his business.
Although nonprofit organizations are not engaged in a trade or business, they are still required to report payments made to ICs. Payments to ICs by federal, state or local government agencies must also be reported.
EXAMPLE: Leslie, owner of an unincorporated home repair business, is paid $1,000 for repair work on a church. Even though the church is a tax-exempt nonprofit organization and is not engaged in business, it must report the $1,000 payment to Leslie on Form 1099.
c. Payments exempt from Form 1099 filing requirement
You don’t need to report on Form 1099 payments solely for merchandise or inventory. This includes raw materials and supplies that will become a part of merchandise you intend to sell.
EXAMPLE: The Acme Widget Company pays $5,000 to purchase 100 used widgets from Joe’s Widgets, a sole proprietorship owned by Joe. Acme intends to fix up and resell the widgets. The payment to Joe need not be reported on Form 1099 because Acme is purchasing merchandise from Joe, not IC services.
In addition, you need not file a Form 1099 when you pay for:
freight, storage and similar items
telephone, telegraph and similar services, or
rent to real estate agents.
You need not file 1099 forms for wages paid to your employees or for payments for their traveling or business expenses. These amounts are reported on Form W-2.
d. No Form 1099 needed for corporations
Subject to only a couple exceptions, you need not file a Form 1099 for payments made to an incorporated IC. This is one of the main advantages of hiring incorporated ICs because the IRS uses Form 1099 as an audit lead.
EXAMPLE: The Acme Sandblasting Company pays $5,000 to Yvonne, a CPA, to perform accounting services. Yvonne has formed her own one-person corporation called Yvonne’s Accounting Services, Inc. Acme pays the corporation, not Yvonne personally. Since Acme is paying a corporation, it need not report the payment on Form 1099.
There are two exceptions to this rule:
1. Payments to medical corporations must be reported on Form 1099.
EXAMPLE: The Acme Sandblasting Company pays $2,000 to Dr. Smith to perform physicals for its employees. Smith has formed his own medical corporation, and the $2,000 is paid to the corporation, not to Smith personally. Nevertheless, the payment must be reported on Form 1099 because Smith is operating a medical corporation.
2. In addition, all federal executive agencies must prepare a Form 1099 for services performed by corporations where the corporation is paid $600 or more during the calendar year. This rule took effect in 1997 and only applies to payments made then or later.
Caution Get the Corporation’s Full Name and EIN
It’s wise to make sure you have an IC corporation’s full legal name and federal employer identification number. Without this information, you may not be able to prove to the IRS that the IC was incorporated. An easy way to do this is to have the IC fill out IRS Form W-9, Request for Taxpayer Identification Number, and keep it in your files. This simple form merely requires the IC to provide his or her corporation’s name, address and federal EIN. (See Appendix 4 and the CD-ROM for a copy of the form. Look under filename IRSFORMW9.)
e. Payments to lawyers
If you pay $600 or more in one year to an attorney in the course of your trade or business—for example, to represent your company in a lawsuit or to draft contracts for your company—you must report the payment(s) on IRS Form 1099. This is true whether or not the attorney works as a sole proprietor, LLC, member of a partnership or a corporation. You do not have to report payments to attorneys for personal matters—for example, to handle your divorce.
There might be times when you will pay money to an attorney who does not represent your company—for example, an attorney who represents a plaintiff who sues your company. If you give an attorney who does not represent you a lump sum of money, but don’t know how much of that money will go to the attorney or how much will go to the attorney’s client, you must report the entire amount in box 13 on Form 1099. For example, if you pay $100,000 to an attorney to settle a case but don’t know how much of the money will go to the attorney, you must report the entire amount in box 13 of Form 1099. If, on the other hand, you know that the lawyer’s fee is $34,000, you would report only that amount in box 7 of Form 1099.
f. Filing procedures
One 1099 form must be filed for each IC to whom you paid $600 or more during the year. You must obtain original 1099 forms from the IRS. You cannot photocopy this form because it is a multi-copy form. Each 1099 form contains three parts and can be used for three different workers. All your 1099s must be submitted together along with one copy of IRS Form 1096, which is a transmittal form—the IRS equivalent of a cover letter. (See below for a sample.) You must obtain an original Form 1096 from the IRS; you cannot submit a photocopy. These forms can be obtained by calling the IRS at: 800-TAX-FORM (829-3676) or by contacting your local IRS office.
IRS Form 1099
IRS Form 1096
Filling out the 1099 form is easy. Follow this step-by-step approach:
List your name and address in the first box titled “Payer’s name.”
Enter your taxpayer identification number in the box entitled “Payer’s Federal identification number.”
The IC is called the “Recipient” on this form, meaning the person who received payment from you. You must provide the IC’s taxpayer identification number, name and address in the boxes indicated. For sole proprietors, you must list the individual’s name first and then may list a different business name, though this is not required. You may not enter only a business name for a sole proprietor.
You must enter the amount of your payments to the IC in box 7, entitled “Nonemployee compensation.” Be sure to fill in the right box or the IRS will deem the 1099 form invalid.
Finally, if you’ve done backup withholding for an IC who has not provided you with a taxpayer ID number, enter the amount withheld in box 4.
The 1099-MISC form contains five copies. These must be filed as follows:
Copy A, the top copy, must be filed with the IRS no later than February 28 of the year after payment was made to the IC; don’t cut or separate this page, even though it has spaces for three workers.
Copy 1 must be filed with your state taxing authority if your state has a state income tax. The filing deadline is probably February 28, but check with your state tax department to make sure. Your state may have a specific transmittal form you must obtain.
You must give Copy B and Copy 2 to the worker no later than January 31 of the year after payment was made.
Copy C is for you to retain for your files.
All the IRS copies of each 1099 form are filed together with Form 1096, a simple transmittal form. You must add up all the payments reported on all the 1099s and list the total in the box indicated on Form 1096. File the forms with the IRS Service Center listed on the reverse of Form 1096.
If you wish, you may file your 1099s electronically instead of by mail. You must first get permission from the IRS to do this by filing IRS Form 4419, Application for Filing Information Magnetically/Electronically. If you file electronically, the deadline for filing 1099s is March 31. For more information, you can visit the IRS website at www.irs.gov. Or call the IRS Information Reporting Program at 304-263-8700.
You may send 1099s to independent contractors via email, but only if the IC agrees. Otherwise, you must deliver the form in person or by mail.