In addition to their full-time employees, many businesses seek the services of independent contractors to supplement their workforce. While outsourcing skills and services is a tale as old as time, the IRS has continuously struggled to maintain effective methods for collecting taxes generated by those being compensated outside the standard W-2 umbrella.
1099 forms, in one form or another, have been used to track payments to nonemployees since the individual income tax commensed in 1918. Before 2020, 1099-MISC forms were used to report all payments made to nonemployees, including compensation, commissions, rents, royalties, awards, etc. Effective tax year 2020, the IRS introduced a new form solely for reporting nonemployee compensation: the 1099-NEC Nonemployee Compensation Form.
While the IRS’s goal was to simplify reporting, the use of multiple forms, differing due dates, and a seemingly endless slew of new regulations has continued to leave businesses baffled by what and how to report different types of payments to nonemployees..
To help bring clarity, here is a basic overview of the different 1099 forms and answers to some common reporting questions businesses often have when the calendar turns to January.
Basic overview:
o A nonemployee is an independent contractor, partnership, estate, or corporation who does not receive a W-2. When a nonemployee is paid $600 or more for professional goods or services, this information must be reported on a 1099-MISC, 1099-NEC, or 1099-K.
o 1099-MISC is used to report payments totaling more than $600 for prizes, rents, awards, and medical and health care payments, OR at least $10 in royalties or broker payments in lieu of dividends or tax-exempt interest. This includes payments made to an attorney for litigation, such as legal settlements or reimbursements.
o 1099-NEC is to be filed when your business pays an independent contractor $600 or more for their professional services, including parts and materials, referrals, and commissions, and for the legal services performed by an attorney.
o 1099-K is filed by third-party settlement organizations when your business pays a nonemployee $600 or more by credit card, payment card, online marketplace, or cash app.
Why is 1099-NEC different from 1099-MISC?
To best understand the difference between 1099-NEC and 1099-MISC, it’s helpful to know why the IRS decided to separate the forms in the first place.
In 2015, the Protecting Americans from Tax Hikes (PATH) Act established a January 31 deadline for reporting nonemployee compensation (NEC) in Box 7 of 1099-MISC forms. This accelerated deadline was intended to allow time for the IRS to review the reported information prior to issuing refunds or credits on returns otherwise due at the end of March (income reported outside of Box 7). As one might expect, filing the same 1099-MISC form with the same employer identification numbers on two separate dates wreaked havoc on the IRS processing systems. After a failed attempt to remedy this situation with Section 202 of the PATH Act in 2018, the IRS concluded that further steps were necessary to rectify the issue.
In late 2018, the IRS announced the revival of the previously retired 1099-NEC Nonemployee Compensation Form to effectively separate the nonemployee compensation reported in Box 7 of the 1099-MISC form. Effective for the 2020 tax year, 1099-NEC forms would need to be filed by January 31, and 1099-MISC would continue to be due at the end of March.
Did reporting requirements change?
Luckily, the basic reporting requirements for nonemployee compensation did not change with the reintroduction of the 1099-NEC form. Specifically, the categorization of “nonemployee” and the type of payments considered “nonemployee compensation” remains the same as in Box 7 of the 1099-MISC form. The significant change is that these payments must be reported separately and earlier than the miscellaneous payments reported on the 1099-MISC in March.
What about credit cards and apps?
If your business made electronic payments to an independent contractor using a cash app, payment card, or other third-party transaction network or marketplace, that information will be reported on a 1099-K Payment Card and Third-Party Network Transactions Form. The good news is that in these situations, the third-party settlement organization is responsible for reporting these payments rather than the business. However, the vast amount of tax dollars going unrecorded in recent years means that the IRS will continue to be focusing on this issue, and businesses should stay apprised of any changes this may mean for their internal processes and reporting.
Previously, 1099-Ks were to be issued when the transactions exceeded $20,000 or the aggregate number of transactions exceeded 200. In 2022, the IRS released guidance to drop the federal threshold to $600 to better align with state regulations and federal 1099-MISC and 1099-NEC reporting standards. This new reporting threshold will take effect for the 2023 tax year.
It is important to note that some states have different rules for reporting 1099-K income, with some states having a lower threshold of $600. Given the recent changes and adjustments to these values, businesses should be prepared to act fast to produce this information should it become required by their particular state.
Do attorney fees need to be reported on both 1090-NEC and 1099-MISC?
Regarding payments to attorneys or law firms (including corporations), only the fees paid to the attorney for their professional legal services should be reported on a 1099-NEC, as that is the compensation specifically for their services. Everything else associated with the litigation, including legal settlements and reimbursements, should be reported separately on a 1099-MISC.
When is backup withholding necessary?
Unlike W-2 employees, businesses are generally not required to withhold taxes for payments made to independent contractors. That’s because the recipient of those payments is presumed responsible for reporting and paying the taxes on that income upon filing their own tax returns. However, there has been an increase in awareness surrounding nonemployee compensation payments and the lack of consistency — and outright absence — of these payments being reported. With this directly resulting in billions of dollars in withholding taxes going unpaid, the IRS will undoubtedly focus on closing this tax gap.
The most straightforward instances requiring a business to withhold nonemployee compensation taxes are when the taxpayer fails to provide a correct tax identification number or inaccurately reports income on their returns. In these cases, the IRS will likely implement a flat rate of 24% backup withholding tax to ensure the necessary taxes are paid in full. Backup withholding will cease when the taxpayer corrects their information and resolves any underreported income.
How do you report withholding tax?
Any federal income taxes withheld should be reported on form 1099-NEC regardless of the amount paid. The amount reported should reflect the gross amount and not the net amount of dollars paid; therefore, do not deduct any credits, fees, or refunds when calculating this value.
Should you report the cost of materials and supplies?
Yes, but only if the cost of the materials, supplies, or goods was included in the total value paid to the nonemployee for their services. For example, if the payment included the cost of professional services in addition to the reimbursement of supplies used to provide those services, then that value should be reported as the total on the 1099-NEC form.
On the other hand, if the cost of professional services and the cost of goods or materials to complete that service were paid as a separate payment transaction, then that value of the “goods only” transaction does not need to be reported on either 1099-NEC or 1099-MISC.
What does 2023 have in store?
Whenever the IRS becomes aware of uncollected tax dollars, more stringent regulations and scrutiny are sure to follow. With an ever-growing pool of independent contractors in the employment market, accurately reporting nonemployee compensation will play a critical role in the 2023 tax year to ensure your organization is in compliance with the filing regulations.
If you have any questions or want more information on how these rules may affect your business, contact me anytime.
Jason LeBlanc joined ARB in 1997 and has been a principal for the firm since 2016. He is the Practice Leader for both ARB’s M&A Advisory Group and Nonprofit Advisory Services Group. Throughout his career in public accounting, Jason’s focus has been on M&A advisory services and providing accounting, compliance, and consulting services to clients in the professional services firms, nonprofit, and automotive sectors. He works extensively with organizations subject to Single Audit reporting requirements.