# Why Does the IRS Care So Much About Employee vs. Contractor?

A few years ago, I was a co-presenter at a seminar on Form 1099. During the segment on “employee vs. independent contractor,” one of the attendees asked the following question: why does the IRS care so much about this issue?

It’s a valid question. Whether you give someone a 1099 or you give them a W-2, the person has taxable income to report. And, a person who receives a 1099 owes self-employment tax, ensuring that the FICA taxes get paid on the person’s pay.

So why does the IRS care so much?

The cynical answer would be, there are penalties to be found in auditing the employee vs. contractor issue.

This is a perfectly acceptable answer, and it may well be the #1 reason why the IRS audits it — they can come after businesses for penalties.

But there are also other explanations.

Tax Calculation — Contractor

Let’s take the example of a contractor who earns \$10,000 from a business. Since the contractor is technically a business owner, he will file a Schedule C. The Schedule C will show \$10,000 of income. Let’s say this person finds \$1,000 of work-related deductions. The Schedule C will show \$9,000 of net income.

In this case, the contractor will pay income tax and self-employment/FICA taxes on \$9,000. Let’s assume that the person or their spouse has other income, and they’re in the 15% tax bracket.

Doing the math:

\$9,000 x 15% = \$1,350 of income tax. Now for the self-employment tax calculation: \$9,000 x .9235 = \$8,312 x 15.3% = \$1,272 self-employment tax.

Now for the off-setting income-tax deduction for the self-employment tax: \$1,272 x 50% = \$636 deduction, x 15% tax bracket = \$94 income-tax savings.

Total tax hit: \$1,350 income tax + \$1,272 self-employment tax – \$94 SE tax deduction = \$2,528 tax hit.

Tax Calculation — Employee

Assume the same circumstances as in the above example, except the person is an employee rather than a contractor.

This person will receive a W-2 showing \$10,000 of income. This income is reported in full on the person’s personal tax return.

The \$1,000 of work-related deductions are only available if the person itemizes deductions. And then, they can only take the portion that exceeds 2% of their AGI. If their AGI is over \$50,000, none of the \$1,000 is deductible.

For purposes of this example, let’s assume that the taxpayer’s AGI is above \$50,000 and they have no other miscellaneous itemized deductions to add to the \$1,000.

How much is the government collecting in this example?

Income tax: \$10,000 x 15% = \$1,500

FICA tax: \$10,000 x 7.65% = \$765 employee half; \$10,000 x 7.65% = \$765 employer half

Total taxes collected: \$1,500 income tax + \$765 employee FICA + \$765 employer half = \$3,030.

DIFFERENCE: \$3,030 – \$2,528 = \$502 of additional income and FICA taxes collected when the person is treated as an employee.

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NOTES FOR THE TAX GEEKS AND MATH GEEKS IN THE CROWD:

• You can play with the employee’s AGI to see what effect a lower AGI would have as far as allowing the employee to claim part of the \$1,000 of work-related expenses. For example, if the person’s AGI was just \$10,000, they’d be able to deduct \$800 of those expenses, saving \$120 of taxes.
• The second example doesn’t delve into the tax savings on the employer side by the employer being able to deduct the \$765 employer-half of the FICA tax. I thought about including this, but at some point, these types of examples become head-spinning with the more details you start layering on. It also doesn’t change the basic point: the government collects more in taxes when someone is paid as an employee.
• Another thing to consider is the government’s collections for unemployment taxes. In Iowa, a typical non-construction business will pay 1% unemployment tax to the state on the first \$28,600 of wages. So in our example, treating the worker as an employee would result in \$100 of unemployment taxes being paid to Iowa. The federal unemployment tax is 0.6% (.006), which would be another \$60 of taxes paid to the feds.