1099s and W-2s are the tax forms employers use to report wages and taxes withheld for different workers. 1099 workers are also known as self-employed workers or independent contractors. These workers receive a 1099 form to report their income on their tax returns. W-2 workers are also known as employees. Your company employs these workers directly, and they receive regular pay and employee benefits. You’ll use a W-2 tax form to report annual compensation and payroll taxes withheld from their compensation.
It’s important to know the difference between 1099 independent contractors and W-2 employees for a few reasons.
- Misclassifying an employee as an independent contractor can result in financial penalties from the IRS or an employee misclassification lawsuit against your business.
- Employee classifications affect how both you and your workers are taxed. You’re required to withhold income taxes and pay taxes on the wages you pay to W-2 employees. You don’t usually have to withhold or pay taxes on the payments you make 1099 contractors.
- Employee classifications determine how much control you have over a worker’s schedule, payment, and other aspects of their job. Independent contractors define when, how, and where they work. Employees work according to your schedule and policies.
Every small business owner should understand the differences between these classifications and when to hire a W-2 versus 1099 worker. But the differences aren’t always clear. If you’re still murky on the details, you’re not alone. Let’s take a closer look at each classification.
How to determine if a worker receives a Form W-2 or 1099
There is no magic formula to determine whether a worker is an independent contractor or an employee. But the IRS does offer some guidance. Three categories determine the degree of control you have over a worker.
- Behavioral: Does the company control or have the right to control what the worker does and how the worker does their job?
- Financial: Does the company or payer control the business aspects, like how it pays the worker? Are the worker’s expenses reimbursed? Who provides the tools and supplies needed to get the job done?
- Type of relationship: Do you have employee policies or offer employee-type benefits like pension, insurance, and vacation pay? Is the work performed a key aspect of the business? Will the relationship continue once the work is done?
As a business owner, it’s up to you to weigh the above factors when determining whether a worker is an employee or an independent contractor. It’s also important to remember that each state has rules and regulations around worker classifications. Unfortunately, no one factor can make that determination.
Some of your answers to the above questions may indicate the worker is an employee. Others may indicate the worker is a 1099 contractor. It’s up to you to consider all the factors, determine the extent of control over the worker, and thoroughly document your final decision.
What is a 1099 worker?
A 1099 worker is a self-employed worker or independent contractor. 1099 workers may also be freelancers or gig workers. Generally, businesses hire these workers to complete a specific task or work on a specific project as defined in a written contract. 1099 workers define for themselves when, how, and where they work. They decide what tools and methods they use to complete the work. They can even choose to hire their own workers to help them deliver the work.
1099 workers may serve multiple clients at one time. These workers are considered “self-employed,” so they pay their own taxes and provide their own benefits. You do not need to withhold or file payroll taxes on their behalf or offer them the same benefits you offer W-2 employees.
Pros and cons of 1099 workers
Whether you hire a 1099 contractor boils down to your business objectives and goals. If you need just one or two specialized projects completed, a contractor may be a good fit. If your business needs are more ongoing, a W-2 employee may be the way to go. As always, there are both advantages and disadvantages to hiring 1099 workers.
Pros of hiring 1099 workers
- They’re experienced. 1099 contractors provide specialized skills and expertise beyond the capabilities of your core team. They are well trained in their fields and bring additional experience to the table.
- Their contracts can be short-term. Typically, companies hire independent contractors for a specific project or amount of time. They can focus on a particular project without increasing your employee headcount or your employee compensation budget. When the contractor completes the project, they move on.
- They can be more affordable. You do not need to withhold or file payroll taxes on 1099 compensation. You also do not need to provide benefits like health insurance or retirement savings to 1099 contractors. Additionally, you can pay contractors per task or project. These factors combined can save you money that you would otherwise spend on employee compensation.
Cons of hiring 1099s workers
- You have less control over their work. Contractors define for themselves when and where they work, the tools they use, and how they do the job. So they may provide a contract that outlines their payment terms, pay rates, and scope of work. Read their terms carefully or agree to mutual terms before you move forward with a 1099 contractor.
- You don’t have the protection of workers’ compensation. You’re not required to provide health benefits or workers’ compensation to your 1099 contractors. But if a 1099 worker gets injured on the job, they could hold your business responsible.
- There are additional legal considerations. While you might be able to fire an employee at-will, dismissing a contractor for any reason could be a breach of contract. It’s good to have a trusted legal professional review the worker’s contract. You might also consider drafting legal protections in your own contract.
What is a W-2 worker?
A W-2 worker is an employee of your business. These employees can be full-time or part-time. Employees work according to your schedule and business policies. They participate in employee benefits programs like health insurance, paid time off, and overtime pay. And they’re guaranteed at least the minimum wage.
You are required to withhold Social Security and Medicare taxes and file payroll taxes for W-2 employees. Additionally, it’s up to you to provide your employees with the tools and supplies they need to get their jobs done. W-2 employee is the default classification for any worker who you can’t classify as a 1099 contractor.
Pros and cons of W-2 workers
W-2 employees come with the benefit of greater control and ongoing support. But those benefits come with a price. When determining whether or not to hire W-2 employees, consider your business needs.
Pros of hiring W-2 workers
- You have more control over their work. Employers have control over employee schedules, business processes, and company policies. And employees are expected to deliver work that meets company standards. If you need help in a certain way at a certain time, hiring an employee makes sense.
- Your company benefits from employee longevity. While contractors tend to jump from gig to gig, employees stay with the company. The longer they stay, the better they understand your business objectives and brand. And they can provide more value over time. Employees can easily shift focus on short notice or wear multiple hats.
- Employees are more committed to your company. Employees can develop a sense of loyalty to your business. This loyalty can translate to a better work ethic, higher morale, and a thriving company culture.
Cons of hiring W-2 workers
- Employees require more time and effort. When you take on W-2 employees, you need to train and manage them. These tasks take an incredible amount of time and energy you might not have to spare.
- You supply the resources for employees. You’ll need to give your employees everything they’ll need to do their jobs. These resources include everything from additional training to tools and materials. And you’ll need to reimburse any business expenses.
- The true cost of an employee is higher than you might expect. Employees cost more than just their salaries or hourly wages. You’re responsible for paying your share of Social Security and Medicare taxes. And you may provide employee benefits like health insurance and paid leave. These costs add up.
Can a worker be both a 1099 and a W-2?
Yes, according to the IRS. There may be instances where a worker serves as an independent contractor and an employee for the same entity. Workers can be both, either concurrently or at separate times, in the same calendar year. The IRS presents the following example:
“Joe is a custodian who works for a county public school. The county views him as an employee and issues him a Form W-2 for these services. He also has a business that he owns and operates that provides snow plowing services on nights and weekends. Any snow plowing services he performs for the county are separate and distinct from his services as a custodian. Therefore, the county should treat him as an independent contractor for his snow plowing business. The county reports this income on a Form 1099-Misc in Box 7, Nonemployee Compensation.”
Note that filing a 1099 and a W-2 for the same worker could result in a tax audit. The IRS will perform such audits on employers if they suspect someone has misclassified an employee.
The tax differences between W-2s and 1099s
Your tax obligations vary between 1099 contractors and W-2 employees. You pay 1099 workers per the terms of their contract. At the end of the year, they receive a 1099 form to report their income on their taxes.
As a business owner, you’re not on the hook to withhold or pay taxes for 1099 contractors. These workers pay their own taxes and provide their own benefits. Because of this—and due to the nature of their expertise—1099 contractors can be expensive to hire.
If you pay a 1099 worker $600 or more for services provided during the calendar year, you’ll need to complete Form 1099-NEC. You must provide a copy of this form to the contractor by January 31 of the year following their payment. You must also send a copy of this form to the IRS. If the contractor hired their own workers or subcontractors while working for you, they’re responsible for filing paperwork for these workers.
W-2 employees receive a regular wage and employee benefits. As a business owner, it’s your responsibility to withhold taxes from their paychecks and report those taxes to the IRS on a W-2 form.
Additionally, you must deposit federal income taxes, unemployment taxes for unemployment insurance, and Social Security tax and Medicare taxes for yourself and your employee. You must report on the taxes you deposit, as well as employee wages, tips, and other compensation. Finally, you must deposit and report your employment taxes on time. The IRS has helpful information on depositing and reporting employment taxes for W-2 employees.
How to calculate the hourly rate differences between W-2 and 1099 workers
You may pay contractors a set amount, either hourly or by the project. Many contractors will outline their payment terms and rates in their contracts. 1099 contractors who are paid hourly may ask for a higher hourly rate than you pay your regular employees. 1099 contractors pay their own taxes and supply their own benefits. So they may need to charge more per hour to cover those costs.
Employment taxes (like Social Security taxes and Medicare taxes) amount to 15.3% of a worker’s gross wages. Employers pay half of this (7.65%) and withhold the other half from W-2 employee paychecks. 1099 contractors pay the full 15.3% themselves from the money they earn. They also need to file quarterly estimated tax payments and pay quarterly estimated federal and state taxes. With this in mind, 1099 contractors need to make a minimum of 7.65% more per hour to cover the employer share of Social Security and Medicare taxes.
How to calculate the salaries and benefit rates of W-2 and 1099 workers
Contractors don’t always get the added benefits of health insurance, paid time off, and other employer-paid benefits that W-2 employees do. 1099 workers have to provide these benefits themselves. As a rule of thumb, benefits are worth about 30% of a worker’s total compensation package, according to the U.S. Bureau of Labor Statistics.
A March 2020 report found that employer costs for employee compensation for civilian workers averaged $37.73 per hour worked. Wages and salaries cost employers $25.91 while benefit costs were $11.82. These benefits include paid leave, health insurance, retirement savings, and other legally required benefits.
Knowing this, a 1099 contractor needs to make a minimum of 30% more than W-2 employees to match employee compensation, including benefits.
Is a 1099 or W-2 worker a better fit for your business?
There’s no right or wrong answer. The type of worker you hire depends on your business needs. If you’re working on a temporary or short-term project, an independent contractor might be the right fit. But if you need temporary help during a busy holiday season, a seasonal W-2 employee is likely the more appropriate choice.
If you need help with your bookkeeping a few hours each week, you could hire a part-time accounting professional. Or you could outsource your bookkeeping to an independent contractor who specializes in accounting. In this case, either worker may be appropriate. If you could use some help with odd jobs, a W-2 employee might be the way to go. If you need someone to hit the ground running, a specialized contractor might be the better choice.
No matter which type of worker you think is a better fit for your business, you should take a look at IRS guidance. And remember that each state has its own set of rules and regulations, so it’s important to classify your workers accurately. If you’re determining when, where, or how the worker completes their assignments, a W-2 employee is the safer choice. And it’s always a good idea to consult an employment law expert when determining employee classifications.
Image Credit: DepositPhotos.com.