It's January--time for ski vacations, daily trips to the gym, weekly trips to WeightWatchers and...preparing your IRS Forms 1099 and W-2. You are required to deliver Form 1099 to any "independent contractor" who provided $600 or more of services to your business during the previous year. Similarly, you must deliver Form W-2 to any person who was an employee last year. Both forms must be postmarked by January 31. Once those are done, you have to file "summary" forms (Form 1096 for independent contractors, Form W-3 for employees) with the IRS by February 28. Here are some tough questions from readers:

I mailed a W-2 form to a former employee who we terminated last July. Apparently the employee moved shortly after being terminated, because the envelope came back to us marked "no forwarding address." What do we do now?

According to Linda Hunt, founder of the financial management firm SumSolutions LLC, if a W-2 is returned to you as undeliverable you should not open it, but rather retain it in your files in the original envelope. "When and if the former employee inquires as to the whereabouts of their W-2, you should make a copy of the returned envelope and re-mail it in a larger envelope," says Hunt. "Do not open it and place the W-2 in another envelope."

Why? By re-mailing the original envelope, you create an audit trail of compliance with IRS regulations requiring that W-2s be postmarked by January 31. If you throw away the original envelope, you will have no proof that you actually mailed the W-2 by that date. The same holds true for 1099 forms.

Our attorney and our accountant are both professional corporations (PCs). Do we still have to send them 1099 forms?

IRS regulations require that attorneys always receive 1099s, regardless of the manner in which they do business. The law is a little fuzzier when it comes to accountants and other professionals, but Hunt advises that 1099s be sent to all providers of professional services, even if they are LLCs or corporations.

A graphic designer performed more than $600 of services for us last year, but she operates as a single-member limited liability company (LLC). Do we still have to send her a 1099 form?

The IRS views single-member LLCs as "disregarded entities"--that is, the IRS does not view them as separate from their owner. Hunt believes the safest bet is to send 1099s to any contractor that is an LLC, a limited liability partnership (LLP), a business trust or other unincorporated business entity, especially if they use their personal Social Security number as their business's tax ID.

Last year we hired someone to act as a consultant to our business. We treated her as an independent contractor, but we only recently learned that we were this person's only client during 2002, and our attorney says there's a possibility this person might be considered an employee of ours. Should we send the consultant a W-2 or a 1099 at this point?

Your attorney is 100 percent correct. Your consultant has failed one of the basic tests of independent contractor status--that the consultant has other clients. Without knowing more about the relationship, though, no one can say for sure if she was or not. For example, if the consultant did all her work at her own location, worked less than 1,000 hours during 2002, and submitted regular invoices for her hourly fees and reimbursable expenses, she may still be considered an independent contractor even though you were her only client. You won't know for sure unless you go through an audit and the IRS agrees with your position.

If you send her a W-2, you are admitting that she was an employee during 2002, and you will be liable for Social Security, Medicare, and federal and state unemployment taxes on the amounts you paid her in 2002 (along with interest and penalties for paying these taxes late). Talk to your attorney some more about this relationship, and see if you have any good-faith defenses to a claim that the consultant was an employee. If the attorney feels that you do, you can send the consultant a 1099 for the 2002 tax year. Just make sure she pays all federal and state withholding taxes on the amounts you paid her last year (don't be afraid to ask for proof, such as a copy of her 2002 tax return). Not a risk-free solution, but the best you can do under these circumstances.

Then, keep an eye on the relationship going forward. If you continue to be her only client, and especially if she is working so many hours that realistically she doesn't have time for other clients, you should put her on the payroll and start paying employment taxes to avoid liability in 2003.


Cliff Ennico is host of the PBS television series MoneyHunt and a leading expert on managing growing companies. His advice for small businesses regularly appears on the "Protecting Your Business" channel on the Small Business Television Network at www.sbtv.com. E-mail him at cennico@legalcareer.com.