Form 1099-NEC vs Form 1099-MISC
The IRS uses various forms to keep track of how much money individuals and businesses have earned over the course of the year. The most common form that we are all used to is the W-2, which employees receive from their employers. Another relatively common series of forms that many of us have seen in one fashion or another is the Form 1099.
The reason the term series is used here is because a Form 1099 can come in a variety of flavors such as one of the following:
1099-G 1099-SSA 1099-INT 1099-DIV
The focus of this article will be on Form 1099-MISC and Form 1099-NEC. This article will explain the use of these forms, the process a business should undergo to fulfil its filing obligations and discuss recent uses of financial technology (FinTech) by business in making payments.
Form 1099-MISC is used to report miscellaneous payments made by a business that are to be reported to the IRS (so that the recipient of the payments pays his or her fair share of taxes). The IRS instructions[i] for Form 1099-MISC give a list of persons and entities for whom a business should file a Form 1099-MISC to report payments. The list is rather long, and without the context of the instructions, rather confusing. Therefore, we urge you to read the instructions for detailed information, including exceptions to filing requirements. The process we describe later in the article may help business owners streamline data collection and filing.
Reading these instructions, we learn one very important change that has taken effect in tax year 2020. Historically, businesses used Form 1099-MISC to report cash and check payments to independent contractors. Starting with tax year 2020, the IRS has re-introduced Form 1099-NEC to report non-employee compensation.
From the same IRS instructions, Form 1099-NEC is to be used for each person in the course of your business to whom you have paid the following during the year:
At least $600 in:
- Services performed by someone who is not your employee (including parts and materials) (box 1);
- Cash payments for fish (or other aquatic life) you purchase from anyone engaged in the trade or business of catching fish (box 1); or
- Payments to an attorney (box 1). (See Payments to attorneys, later.)
You must also file Form 1099-NEC for each person from whom you have withheld any federal income tax (report in box 4) under the backup withholding rules regardless of the amount of the payment.
Sidenote: does the IRS not trust attorneys to report their income?
Anyway, time for a real-world example. Joe Shmoe Handyman Services (JSHS) is owned by Joe Shmoe, who typically handles all jobs by himself. JSHS lands a big contract and needs help. Joe Shmoe decides to get help from his neighbor Mike. JSHS will pay Mike $1,000 for 40 hours of labor.
Since JSHS is paying Mike at least $600, JSHS is required to file Form 1099-NEC to report this payment to the IRS so that Mike pays income tax on his earnings. At the end of this article, an outline of a simplified process is shared to help business owners make this easier.
Let’s talk about FinTech, credit cards, and what to do with these.
FinTech in the context of Form 1099s and this article is regarding payments made via third-party payment systems such as PayPal, Venmo, Zelle, CashApp, etc. as well as credit and debit cards.
Let’s tackle the easy one first: debit and credit cards. If a business makes a payment via debit or credit card, then there is no need to issue a Form 1099 for the payment made via debit or credit card. The payment processing company may issue a Form 1099-K to the recipient if certain thresholds are met, but that is not the concern of the small business making the payment. Said another way: if a small business makes all of its payments to third parties via debit or credit card, then it won’t have to worry about Form 1099. Hello credit card points!
The more complicated area concerns payments made via PayPal, Venmo, Zelle, CashApp, etc. We’ll call these collectively “FinTech Systems.” The reason this is more complicated is because almost all FinTech Systems have a “personal/friends and family” setup and a “business” setup. If a small business correctly sets up the business account… meaning registering the business as the account owner, not merely linking the business bank account, then the business does not have to worry about Form 1099s.
However, the circumstances are quite different in the case that one has a personal PayPal account, links the business bank account, and then makes a payment to a payee using this personally owned account. In this scenario, the payment needs to be reported via one of the Form 1099s, assuming it meets all other reporting requirements.
What process should small businesses like JSHS have in place?
It is strongly recommended that every business owner read the instructions for Form 1099-MISC and 1099-NEC at least quarterly to remind him or herself of what the requirements are. But that sounds like too much work! Doesn’t JSHS have an accountant who can handle this for the business?
One of the key components to filing any informational return is gathering the correct information up front, before any payment is made! This is the biggest mistake we see clients make. Before a business makes a payment to another person or entity, the business should request a completed Form W-9 from the party receiving the payment. Once the payment is made, the party receiving the payment has no incentive to give the business a Form W-9. Unfortunately, too many small businesses are chasing W-9s in January, scrambling for information so they can meet their filing requirements.
Why is this so important?
Because the penalties for not filing informational returns are astronomical[ii]. If the IRS finds a small business to “intentionally disregard” its requirement to file an informational return, then the penalty is $550 per return! Imagine that you were supposed to file 10 Form 1099’s per year, and the IRS audits 3 years of records. That’s $16,500 in penalties, plus interest.
Here are some steps on how a business can minimize its risk:
- The business making a payment needs to get a Form W-9 each and every time before the business makes a cash, check or FinTech System payment to a sub-contractor, vendor, attorney, landlord, or any of the other payees that are listed in the IRS instructions.
- If the business uses a payroll company, it is ideal to make payments to independent contractors through the payroll system. The payroll system will require a Form W-9, will record the payment correctly, and the payroll company will issue Form 1099 on behalf of the business at year-end. In the case that a business must pay an independent contractor or vendor on the spot, the business should report the cash/check/FinTech System payment to the payroll company so that they can “true up” the total paid to this payee and have the correct information for Form 1099 filings.
- If the business does not use a payroll company (such as in our example where JSHS was a one-person business without payroll), then the business owner should meet with his or her external bookkeeper/accountant in the 4th quarter to review payments, gather a list of payees and amounts, and determine who will file Form 1099s for the business.
In summary, business owners need to be aware of informational return filing requirements, gather Form W-9 for any person or entity that is paid via cash, check or FinTech System, and have a procedure in place to file the informational returns, whether using an existing payroll processing company, accounting firm, or doing it in-house.