2.4 Other Tax Documents

Some taxpayers may come to you with copies of tax returns, a Form W-2, or a Form 1099. A Form W-2 reports the wages paid and the taxes withheld for an employee in a certain year. A wage employer should automatically deduct Social Security and Medicare taxes from each paycheck (i.e., FICA). Federal income tax can also be deducted at the discretion of the employee. Many wage workers incur tax liability because they do not have the proper amount of income tax withheld from their paychecks. 

Form 1099 reports income other than employee wages and comes in various types identified by the letters following the 1099. For example, a Form 1099-C reports debts that have been cancelled by a creditor. A Form 1099-MISC is generally issued by employers for contractor compensation or by lenders or other creditors who have cancelled a taxpayer’s debt. A Form 1099 may also be issued by an opposing party in personal-injury litigation for the portion of a settlement that may be taxable income, e.g., lost wages or attorney fees.

If the Form 1099 is from an employer, there may be an issue as to whether the client has been properly classified as a contractor instead of an employee.1 A taxpayer who truly is a contractor is responsible paying the Social Security and Medicare taxes that are automatically deducted from an employee’s wages. The taxpayer is also responsible for paying estimated taxes every quarter to cover the income tax that is usually deducted from an employee’s paycheck.

If the Form 1099 is from a lender or creditor, the issue will be whether the debt cancellation can be excluded from the taxpayer’s income. Normally, cancelled debt is considered income in the year of cancellation and must be reported on the tax return. Failure to report Form 1099 income usually leads to an audit in which the taxpayer must justify why the debt cancellation is not income.

• 1For a more complete discussion of misclassification, see Section 17 of this chapter and Section 3 of the chapter on Employment Law.