W-2s, Form 1099s, and Taxes
"What is the tax implications on a [Form] 1099 vs. a [Form] W-2? [e].g. if  20k was issued under a W-2 what’s that after tax v. 20k issued on a 1099 after tax?"
In the employment context, Forms 1099 and W-2 are used to report income to the IRS paid to people who work for a business. Form 1099 is used for independent contractors – the typical example is a professional such as a lawyer, accountant, or consultant who exercise their own discretion as to how work is completed. Form W-2 is used for employees – the traditional job where a person performs tasks as directed by their boss. The IRS has a set of criteria that determines on which side of the employment / independent contractor divide that a particular arrangement is which is another topic for another day. However, key differences between Form 1099 contractors and Form W-2 employees are withholding and employment taxes.
The federal income tax and employment taxes are pay-as-you-go systems. Throughout the year, individuals and businesses are expected to make regular payments on their tax liabilities. Form W-2 employees have their taxes withheld from their paychecks and sent to the IRS usually every pay cycle. Form 1099 contractors on the other hand receive their entire paycheck but are required to make estimated tax payments at least quarterly to the IRS.
Going back to the question, assume Taxpayer A and Taxpayer B both earn $20,000 of income in 2009. A works for an employer and receives a W-2 at the end of the year. B is a self-employed independent contractor (as a sole proprietor) and receives a Form 1099 at the end of the year.
A and B’s federal income taxes before deductions are the same as they both earned $20,000 of income. A reports his income from Form W-2, Box 1 on Form 1040, Line 7 – Wages, salaries, tips and attaches a copy of his Form W-2. B reports his income from Form 1099, Box 7 on Form 1040 Schedule C, Line 1 which is carried to Form 1040, Line 12.
Where things diverge are the employment taxes, commonly known as FICA (Federal Insurance Contributions Act). A, as an employee pays the employee rate of 6.2% for Social Security and 1.45% for Medicare for a net total of 7.65% or $1,530 in employment taxes. A’s employer pays the other half of the FICA contribution (at the same rates) for a total contribution of 15.3%.
B as an independent contractor must pay both the employee’s and employer’s portion for a total of 15.3% or $3,060 in employment taxes on Form 1040 Schedule SE. However, B receives a deduction in the amount of half of the FICA contribution as an ordinary and necessary business expense just as A’s employer does for its contribution (Section 162 for those who keep track of Code sections). This reduces B’s taxable income by $1,530 to $18,470.
So at the end of the day with all other things equal, A has received cash of $18,470 after employment taxes and has taxable income of $20,000. B has received cash of $16,940 after paying employment taxes but has taxable income of $18,470. Although B has less taxable income subject to the federal income tax, B also had to pay out both portions of FICA leaving him with less cash in his bands compared to A.
All is not that bad for B though. In addition to FICA, A’s employer must also pay FUTA (Federal Unemployment Tax Act) at a rate of 6.2% for the first $7,000 of wages. B, as a self-employed independent contractor does not. Now although A does not have to pay FUTA as it is only charged to the employer, A’s employer must make extra cash outlays to cover that liability which reduces the amount of money the employer has to pay its employees.
In addition, B as a self-employed independent contractor can take deductions for ordinary and business expenses. Now although A can deduct certain unreimbursed employee expenses such as job travel, union dues, job education, etc, A can only take those deductions if A chooses to itemize deductions and may only deduct those expenses to the extent they exceed 2% of adjusted gross income (commonly known in tax circles as the 2% haircut or floor). Assuming A’s AGI is $20,000, A can only deduct those unreimbursed expenses if they exceed $400 and even then only the portion that exceeds $400 on Form 1040 Schedule A, Line 21. B is not subject to this 2% floor.
On a straight comparison, it would appear that Taxpayer A is better off since although A may pay a little more in income taxes, A does not have to pay out both portions of FICA as his employer pays half (effectively, A is paid $21,530 although only $20,000 is taxable). However, Taxpayer B can come out ahead through smart use of business expenses that A may not be able to deduct to make up for the difference as well as costing his employer less in cash outlays compared to the equivalently paid employee which may actually get him the work as opposed to the employee.
Like may problems, although we can try to focus on one part to find a solution, often times it requires looking at the big picture to see the goal. Although looking at how Forms 1099 and W-2 income get reported and taxed is important, the larger picture includes how much an individual costs their employer to hire and the availability of deductions. And at the end of the day, what matters is the cash in your pocket that you have to spend on the finer things in life – I hear wine and steak go well together.
For additional information, see IRS Publications 15 (Circular E), Employer’s Tax Guide (http://www.irs.gov/publications/p15/index.html) and 334, Tax Guide for Small Business (http://www.irs.gov/publications/p334/index.html).
Disclaimer: As a tax attorney, I must remind you that the tax laws can and do change over time. Before you rely on information given here, you should contact a tax professional authorized to practice in your jurisdiction to discuss your particular facts and circumstances.