It’s no surprise that many employers struggle with the classic W-2 vs 1099 worker dilemma when looking for the best candidates for any given job. The more you look into the differences between direct employees and independent contractors, the more confusing and ambiguous it becomes due to the IRS’ fuzzy legal definitions.
This decision is likely more important than you think. It’s obvious that choosing the right kind of worker for each job is instrumental for building a great team but it’s more than that. Misclassifying workers could result in severe fines and even jail time.
That’s why we want to use our extensive experience in hiring and personnel management at Business2Community to help you fully understand the problem and make the best hiring decisions that you can.
Throughout this article we will explain the differences between the 2 classifications, explore what kind of worker is best for certain kinds of businesses, dive into the general pros and cons of contractors and full employees, and detail the employer tax obligations that come with them.
W-2 vs 1099: Difference Explained
|Form 1099||Form W-2|
|Who gets it?||Clients issue independent contractors 1099 forms and the IRS is sent a copy||Employers issue direct employees W-2 forms and a copy is sent to the Social Security Administration (SSA)|
|What does it report?||Gross compensation paid by the client and (usually) no tax information||Direct employee taxable pay as well as witheld compensation such as federal, state, and local income tax and FICA tax|
|When is it due?||January 31st||January 31st|
|Can you file electronically?||Yes||Yes, with the employee’s consent and the appropriate disclosures. Filing 250+ W-2s must be done electronically unless the IRS approves otherwise|
A 1099 form and a W-2 form are entirely different and so are the roles of workers that are issued each. Direct employees whose work is under the direct control of the employer file W-2 forms whereas independent contractors file 1099 forms.
The difference between contractors and regular employees comes down to the control the employer or client has over the work. To determine whether a worker is an independent contractor the IRS performs a common law test, often called the IRS 20-factor test or the “right-to-control” test.
A few of these factors include flexibility of schedule, continuity of the relationship, whether it is full-time work, payment methods, reimbursement of expenses, and the provision of tools or materials. No single factor considered in the test is decisive, which can make the classifications a bit ambiguous. Instead, the IRS looks at the circumstances surrounding each factor and weighs them accordingly. If the employer or client seems to have great control over the work across most or many of the factors, then the IRS is likely to classify the worker as a full employee.
The gig economy is expanding faster than ever before and is estimated to reach 455 billion in gross volume by the end of 2023. rapidly expanded – not only in the US but globally – a lot of companies are now looking to hire independent contractors and similarly a lot of workers see the benefits of working as independent contractors.
W-2 vs 1099: What Is a W-2?
A W-2 form is one that the employer provides to employees to aid in filing their income tax. It has details like wages paid during the year as well as the various payroll taxes withheld by the employer. These include the withheld federal income taxes, social security tax, and Medicare tax – details that the worker will need when filing their personal tax returns.
The document is essential for employees when tax day rolls around as it provides them with most of the information they need to file.
W-2 Employee Tax Obligations
When your company employs W-2 workers, it is responsible for calculating and deducting various taxes from the employee’s pay.
Typically, companies need to withhold taxes for W-2 employees for the following purposes:
- Federal income tax
- State income tax, if applicable
- Local income tax, if applicable
- Medicare and Social Security taxes
Apart from withholding income taxes for employees, employers are also required to pay their share of their employees’ Social Security and Medicare taxes. Workers pay half of these liabilities while the remaining half is paid by the company and is considered as employee compensation.
Employers are also responsible for reporting payments and filing taxes in a timely way. Notably, you’re going to need to withhold income taxes and provide the W-2 for all eligible employees ahead of the tax season, and failing to do so for even one employee might have legal repercussions. You also probably need to pay unemployment insurance taxes annually by filing IRS Form 940 which goes to support workers who lost their jobs.
Examples of W-2 Workers
When you think of W-2 workers, they are the traditional employees that can either be full-time or part-time. Common examples include:
- Software engineers working in tech companies
- Unionized workers working at steel, auto, and other industrial companies
- Uniformed workers of the armed forces
- Police personnel
Benefits of Hiring W-2 Workers
There are multiple benefits as well as some disadvantages of hiring W-2 workers. The benefits to you as the employer include:
- W-2 workers typically with you for the long haul and can be trained in multiple job functions.
- Strong W-2 employees can rise the corporate ladder and might even reach top leadership positions.
- W-2 employees might be better aligned with the organization’s goals and missions and might gel better with other employees as compared to self-employed contractors who are more focused on their own business.
- Trained and skilled W-2 employees are among the biggest strengths of companies, especially in the current knowledge economy.
Disadvantages of Hiring W-2 Workers
Meanwhile, like most things, there are some disadvantages to hiring W-2 workers. These include:
- You need to provide employee benefits including health insurance when you hire W-2 workers.
- You have to pay for half of your employee’s Social Security and Medicare taxes
- You may need to invest time and money in training W-2 employees which you need to budget for.
- Your small business may need additional resources or payroll software to prepare, file, and pay payroll taxes for W-2 employees.
W-2 vs 1099: What Is a 1099?
According to the IRS, a 1099 is an information form and is further divided into Form 1099-MISC and Form 1099-NEC. The Form 1099-MISC is used for miscellaneous payments like royalties, rents, prizes and rewards, payments to an attorney, crop insurance proceeds, etc.
The Form 1099-NEC is used to report to report non-employee compensation. It is provided to someone who is not an employee of the organization and often falls into one or more of these categories.
- Self-employed: Someone who works for their own business.
- Freelancer: A self-employed contractor without a long-term commitment to any single employer who often works more at the direction of the client than other contractors.
- Business owner or sole proprietor: Freelancers (in the US) are automatically business owners, even if they don’t file to create a separate company.
- Gig worker: Independent contractors who often work on a number of short-term projects for various clients.
One of the most important differences between W-2 and 1099 workers is that your company does not withhold federal or state income tax for these individuals and does not pay employment taxes on their behalf.
Simply put, a payment made to a 1099 worker is non-employee compensation for the company and is paid to individuals who provide services without being on the company payroll.
Who Is an Independent Contractor According to the IRS?
Some people just think of uber drivers, construction workers, or freelance writers when they think of independent contractors but almost any job can be filled with a contractor.
According to the IRS, “The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done.
“They are treated as self-employed workers and are subject to self-employment tax.
The IRS adds, “You are not an independent contractor if you perform services that can be controlled by an employer (what will be done and how it will be done). This applies even if you are given freedom of action. What matters is that the employer has the legal right to control the details of how the services are performed.
“The key aspect here is the “employer-employee relationship” and how much control the company has over the worker.
If the worker has an employee-employer relationship with your company, then they are a W-2 employee and you will need to offer all the associated benefits like health insurance, and social security – and you will would need to withhold taxes on their behalf.
From the company’s perspective, the payment made to an employee would be categorized as payroll expense as they are on the employer’s payroll. However, any payment made to independent contractors is eligible to be classified as a business expense therefore is tax-deductible as it is non-employee compensation.
Check out Yahoo Finance’s video for a quick explainer about independent contractors if you want to learn more:
1099 Independent Contractor Tax Obligations
Usually, companies don’t have tax obligations for 1099 independent contractors and they are responsible for their own taxes. This is one of the greatest advantages of using contractors over full employees.
Typically, independent contractor should pay their estimated taxes every quarter and file their return annually. If they don’t, they will be fined, depending the amount of taxes that go unpaid and the length of time that it goes unpaid.
1099 independent contractors need to pay self-employment tax of 15.3% of their income, split into 2.9% for Medicare and 12.4% for Social Security. They are also responsible for paying state, federal, and local taxes.
Independent contractors may have to pay the IRS more on tax day but they can also write off business expenses to lower their tax bill. These expenses can include operating expenses, supplies, your home office, and even snacks and coffee (but only if these things are only used for the business).
W-2 vs 1099 Workers: Which Is Each Best For?
When you are hiring workers, you need to decide on whether you need a full employee or an independent contractor. Both types of arrangements work well in different scenarios.
When 1099 Contractors Are Often the Best Choice:
- When you want to hire workers with specialized skills immediately but don’t have time to train them
- When you need short-term or project-based help
- If you don’t have the ability to pay for extra benefits like health insurance and withholding taxes
- When you need a flexible worker to pick up an unpredictable workload outside of the usual 9-5 shifts
- If you run a seasonal business and need workers for only a specified period, then self-employed workers and contractors may fit your needs.
When W-2 Workers Are Often the Best Choice:
- If you need to control how the work is done, not just the result
- When the job market is competitive and the worker could get great benefits elsewhere
- You want long term and loyal employees
- When staff who can work multiple functions and not necessarily one specific job are needed
- If the position has confidentiality requirements
- When strong collaboration with other parts of the company is needed
- When you need exclusivity and dedication from the worker
Benefits of Hiring of 1099 Workers
Hiring 1099 workers has its own set of advantages and disadvantages. The advantages include:
- Hiring independent contractors can be cost-effective in many cases as you don’t have to provide the same employee benefits as W-2 workers.
- Independent contractors can help bring new insights and skill sets to your organization.
- Contractors are generally much more flexible
- Less administrative and management work is needed to support contractors (generally)
Drawbacks of Hiring 1099 Workers
Meanwhile, there are some drawbacks when you hire an independent contractor. These can include:
- 1099 workers typically have a short-term view and likely aren’t loyal to your company
- Your company will have less control over the work and how it is completed
- Your business might not own the copyright for the contractor’s work unless it is specified in the contract.
- There could be a greater risk of data breach or IP theft
W-2 vs 1099: Differences in Hourly Rate, Salary, and Benefit Rates
The compensation structure of an independent contractor is quite different from a payroll employee because they don’t get the same benefits. Because of this difference, they tend to command a higher hourly wage as compared to normal employee, especially if they are highly skilled or in large demand. Be prepared for this!
When devising a payment system for an independent contractor, you need to take into account the total employee compensation package, not only the hourly rates. Employee workers’ compensation also includes overheads like healthcare insurance and retirement plan contributions – while non-payroll workers don’t get such benefits and hence the higher hourly wages should also account for these.
W-2 vs 1099: How to Choose Which Is Better for Your Business
Both 1099 and W-2 workers can be a great choice for your business depending on its needs. Most companies typically use a mix of both. Be careful when making the decision between hiring contractors and full employees. It will take a considerable amount of planning and strategizing to land on the best strategy.
First, come up with a list of every job that you need to be filled. Next, go through them one-by-one and consider all of the main factors including:
- Is this a long term position?
- Do we have enough capital to pay for benefits and payroll taxes?
- Do we need a loyal employee to keep IP, secrets, or data safe?
- Is it important to control how the work is done?
- Do we need to hire immediately?
- Is this position in the job market competitive?
If the answers to all of these questions are all yes, you probably need a w-2 employee. If they were all no, you may benefit more from hiring an independent contractor. If you landed somewhere in between, work out which of these factors is more important for your business and make your decision accordingly. These considerations are all extremely important but the decision will come down to the reality of current job market and whether you can find a qualified full employee or contractor.
Risks of Misclassifying Workers: Liability for Income Taxes
There are penalties associated with employee misclassification and according to the IRS, “If you classify an employee as an independent contractor and you have no reasonable basis for doing so, then you may be held liable for employment taxes for that worker.”The various risks of misclassifying a W-2 employee as a 1099 worker include:
- You or your company might be liable for criminal penalties as well as back wages if it misclassifies a W-2 employee as an independent contractor.
- The law allows for a sentence of up to 1 year in prison for misclassifying workers as well as a fine of $1,000 per affected worker.
- Your company could be liable for not withholding taxes as required by the applicable law and would also need to pay the unpaid unemployment taxes.
Additional Penalties for Worker Misclassification
As the business owner, you should know that your company would need to pay a $50 fine and a penalty equating to 1.5% of the worker’s wage for not filing the W-2 form for the employee. The company is also liable to pay all the FICA taxes (Social Security and Medicare taxes) that it would of paid if they were classified correctly and an additional 40% of the worker’s FICA taxes.
Check out attorney Aiden Durham’s video covering the IRS’ rules regarding classifying employees for an even more in-depth breakdown.
W-2 vs 1099: The Bottom Line
Overall, both 1099 and W-2 employees could potentially fit your business’ needs and you will need to decide which works better. Independent contractors are increasingly becoming popular as the gig economy expands but W-2 workers still make up the foundation of almost every workplace.
From a worker’s perspective, while some prefer the freedom associated with being a freelancer, others prefer the benefits that W-2 employees get.