Sam’s Story Part Three: Subcontractor or Employee?

Welcome to the ‘Sam’s Story’ series, where we cover common accounting topics in a real-world scenario. This week we’re talking about subcontractor vs employee status, which category Sam’s staff fits into, and the options he has when it comes to processing payroll.

Sam’s Story Recap

If you haven’t read any of our previous Sam’s Story articles, catch up on them now!

Sam’s Story Part One: Selecting a Business Entity for a New Business

Sam’s Story Part Two: Accrual vs Cash Accounting

W-2 Employees vs. 1099 Subcontractors

Sam discussed his new work staff with another business owner at a Chamber of Commerce mixer. He was told that he could save a lot of money by paying his staff as “subcontractors” and issuing them 1099s at the end of the year. Like so many other things Sam heard recently, he thought this sounded too good to be true. He decided to ask me, his accountant, what would be the best way to handle paying his staff.

I explained that the savings Sam heard about are payroll taxes and insurance. As an employer, he must pay Social Security and Medicare taxes for each employee, which is equal to 7.65% of their wages. Sam is also responsible for unemployment compensation insurance and workers compensation insurance. Both of those vary from year to year, but can add up quickly.

How to Decide Which Option to Use

When hiring “subcontractors”, Sam is not responsible for the payroll taxes or the insurance. Sam noted, “That’s seems easy enough, why wouldn’t everybody have subcontractors rather than employees?” I replied, “You can’t just decide they are all subcontractors. The difference between an employee and a subcontractor depends on your right to direct and control the worker. In determining the employment tax status of a worker, the IRS considers three categories of evidence: behavioral control, financial control and relationship of the parties.”

IRS Categories of Evidence

Behavioral control relates to whether the employer has the right to direct and control how the work is done. Financial control deals with whether the employer has the right to direct and control the economic aspects of the work. Finally, the relationship of the parties looks at how the business and the worker view their relationship. The IRS takes employee benefits and written contracts into consideration when examining the relationship.

After hearing these guidelines, Sam reached a conclusion about his workers. His wait, bartending and kitchen staff would be treated as employees. Any live entertainment he hires would be considered subcontractors. Sam made the right decision and quite possibly saved a lot of grief and penalties in dealing with the government.


Payroll Processing Options

Sam, from Sam’s Sports Bar, LLC, also stopped in last week to discuss payroll. It seems that Sam’s buddy, Ted just had a visit from the IRS concerning payroll for his staff. The IRS told Ted that his staff had to be paid at their gross wage amount and have federal, state and local taxes deducted to come up with a net amount that a check would be cut for. Apparently, Ted had been just giving his staff cash at the net amount and was in big trouble with the IRS. Sam gets a lot of advice from Ted and he wanted to make sure he was doing it correctly. Fortunately for Sam he was. I told Sam he needed to explain to Ted what his options were for running payroll.

Option one – Do it yourself.

This option is by far the least expensive in the short term but also potentially the most expensive in the long run. Not only do you have to calculate the gross wage amount correctly, but you also have to prepare and file federal, state, local, federal unemployment and state unemployment tax returns and make all the payments timely and, in this day and age, electronically.

Option two – Outsource it.

This option costs a little more but will save you in the long run. You turn in your hours to a third- party service bureau that will accurately calculate the gross to net amounts. The third party will take full responsibility for preparing and filing all the taxes, including the year-end filings necessary. They send you the checks completed and ready to hand out to the employees.

I told Sam to have Ted give us a call and we could help him in this area.

Come Back for Sam’s Story Part Four!

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