1099 Contract Worker vs. W2 Employee: What’s the Difference?

Once your business begins to grow, you may be faced with the decision to hire part-time, full-time, or contract-based workers. Historically, businesses have been able to take advantage of many great and cost-saving benefits when using contract workers. However, the previous definition of contractual laborers no longer applies to some of your workers, and Credibly explains how this change can affect your business costs.

Will the Cost of Employee Benefits Outweigh the Benefit of Hiring a Contract Worker?

Since the passage of the Affordable Care Act, you may be required to provide health insurance to your employees, depending on the number of employees you hire. If you have less than 50 employees, you’re not required to offer health insurance. Previously, you could have used contract workers to avoid this situation and scale your business to meet your consumer demand. However, the changing definition of an employee poses serious implications for this common practice.

How Much Do You Need Additional Staff?

Your first consideration when hiring staff should focus on how many hours you need covered. If you need at least one staff member for a full-time position, you may want to consider hiring a true employee. If you have rare needs, such as a single shift per week, consider hiring an independent contractor.

Why Is the Definition of an Employee Changing?

Many workplace rights have roots in the early 19th century, explains CNN. However, many modern labor agencies, such as those that classify workers as independent contractors, have sought to prevent workers from unionizing and gaining employee-based rights. Compare how statistics of unionized laborers have changed in the last 30 years: In 1983, 17.7 million workers were members of a labor union. In 2014, this number had dropped to 14.6 million. 2.87 million workers were classified as independent contractors in 2014, reports the Portland Press Herald. This reflects the growing surge towards employing independent contractors in place of actual employees. However, America’s workforce demands stronger representation and equal rights, and authoritative entities are starting to change things.

The National Labor Relations Board, under the authority of the US Department of Labor, is responsible for determining what defines an employee. For example, contractual workers have been routinely classified as independent contractors. However, the NLRB is attempting to modify the standard definition of an employee to include such contractors. This comes as a result of contractual and franchisee employees seeking a resolution to unionize in large-scale forces. In other words, contractual workers should be able to join in your company’s voice, and therefore, in your company’s employee benefits.

What Does a New “Employee” Definition Mean For Your Business?

Now, consider how changing the definition of an employee would affect the cost of a contractual labor. Depending on the NLRB’s final ruling, contractual workers may be reclassified to obtain the same benefits as your traditional employees. As a result, you may need to offer paid time off, FMLA allowances, and insurance benefits to contractual workers in the future. Furthermore, you can’t escape the costs of these benefits to your own employees by outsourcing job duties. Consider this scenario:

With 46 employees, your business currently employs less than 50 people. You need to increase your staff by six additional positions for the holiday-rush. Unfortunately, this places you in the mandate to offer health insurance. Previously, you could have avoided this requirement by hiring three workers and outsourcing the remaining positions to independent contractors. With the NLRB’s ruling, the contractual workers will now count towards your total number of employees.

Ultimately, you must review how each decision will affect your overhead costs.

1099 vs. W-2

A 1099 and a W-2 are both tax forms. A 1099-MISC is for independent contractors that you pay, but they pay their own self-employment taxes. A W-2 is for employees you pay and you withhold their payroll taxes.

1099: Independent Contractor

An independent contractor is technically self-employed and pays their own taxes. As the business owner, you would hire an independent contractor to complete a specific project or task. For example, if you have a cleaning service or freelancers, these people would likely be independent contractors. You do not provide employee benefits for independent contractors and you will pay their rate rather than offering them a salary.

Independent contractors keep track of their own self-employment tax, paying for their own benefits and saving in their own retirement plans.  However, you still are required to issue a 1099-MISC form that provides the total amount that you paid them for their services.

On the flip side, you as the small business owner may actually be the independent contractor. If you have your own business and provide services to another business as a sole proprietor, you are likely an independent contractor. While the company you provide services for is required to issue a 1099-MISC, you are also required to keep track of your own income from business activities. Even if that business never issues you a 1099-MISC, you still need to report any funds you receive as business income.

W-2: Employee

A part-time or full-time employee is someone who you hire to work for your company. Regular employees get hourly or salary paychecks and may provide any range of services for your business. You also need to execute tax withholding for employees. FICA, a federal law, mandates that all employers withhold social security taxes and Medicare taxes from employee paychecks. Employers also have to make tax payments into these programs and pay unemployment tax.

In addition, you provide benefits for your employees, such as health insurance, paid time off and paid leave. You also have to pay into unemployment insurance and worker’s compensation if you have employees, so that your employees are covered if they are laid off or injured on the job.

While you may read this and think you should hire everyone as an independent contractor to help your bottom line, think again. There are serious penalties for trying to evade the system by hiring “independent contractors” who are really functioning as employees.

Beware of Independent Contractor Misclassification

The IRS is rather vague about the difference between an independent contractor and an employee but assumes that someone who regularly works for you is an employee unless proven otherwise. The difference in worker classification between an independent contractor and an employee depends entirely on the “type of relationship” that you have with the person. Ask yourself the following three questions:

1. Do I have a formal written contract with this person that establishes employment?
2. Do I set the date, rate, and method of payment for this person?
3. Do I have the right to control how this person does their job with performance evaluations?

If you answered yes to any or all of these questions, you likely have an employee. If you do not have an employment contract, the person sets their own pay rate with invoices or business expenses, and you have no control over their services (other than to not hire them again or leave them a bad review), then you likely have an independent contractor.

Be very careful not to misclassify an employee as an independent contractor. If you have misclassified workers and this comes to light, you may owe a lot of people a lot of money. You will owe the IRS back taxes, and you will owe the employee compensation and benefits. This financial penalty can be a significant hit to your business and it is better just to be honest from the start rather than trying to game the system.

Pros and Cons of 1099 Contractors vs W-2 Employees

While it may seem like employees are just plain more expensive, there are plenty of benefits to hiring employees. There are also benefits to having independent contractors beyond saving cash. This is a brief overview of what to consider when deciding who to hire.

Loyalty

Loyalty is a pro for employees and a con for independent contractors. Employees identify with your business, spend more time there and make connections with other employees and your clients. Independent contractors are loyal to their own business and don’t integrate with your teams as much. When push comes to shove, having employees who are willing to work an extra hour when you are in a pinch or do something that isn’t in their job description because someone is out sick can be a key aspect of the business’s success.

Expertise

Expertise is a pro for independent contractors and a con for employees. Independent contractors provide the same service repeatedly and often have years or decades of specific experience. For example, a cleaning service knows protocols for cleaning a workplace, brings their own supplies, and has established systems for efficiency. Sure, your employee could mop the floor, but it is unlikely that you are going to get the quality of work from someone who has never cleaned a commercial space.

Output Control

Output control is both a pro and con for both, depending on your business needs. You have a greater degree of control over employees’ output because you can provide training and give feedback on job performance. On the other hand, independent contractors do their job independently and essentially the only feedback you can give is to not hire that independent contractor for the next job. Employees are a bigger investment to hire and train, but can also provide a return on investment for years. Independent contractors complete a task and leave. Which option is better for you depends on what your end goal is.

Key Comparisons to Make Between Employees and Contractors

The best way to approach the new definition of an employee is to consider that any person who performs work for your business, even if the worker is an independent contractor, is your employee. However, you must also consider the following costs:

• How much will you need to pay in health insurance for your employees if you have at least 50 employees?
• How much do you spend in training costs? For example, an employee who requires one day of instruction will incur the cost of the person training him and the cost of the new employee’s daily rate.
• How much would you spend in pre-employment eligibility screening? This includes costs for drug tests, background checks, and time spent checking credentials.
• Does your contracting agency require a minimum number of hours and placements per time period? For example, would you be obligated to using contracted workers for X number of hours every month or quarter?

By understanding how the definition of an employee affects your business, you’ll be better prepared to decide between hiring your own employees and using third-party contractors.

1099 Form vs W-2 Form

Form 1099-MISC and form W-2 are very similar IRS forms, but they contain different information. Because no taxes are withheld for a contractor, a 1099 is just a document with the total amount paid to the independent contractor during the tax year. On the other hand, a W-2 tax form contains information about gross salary, taxes withheld and benefits, such as retirement. Either way, you will need to keep your books updated throughout the year, either by hand or using a payroll service.

The differences between a 1099 independent contractor and W-2 employee may seem daunting at first, but you can consult local business development and SBA support centers for advice. If you hire an accountant or payroll service, these people can also provide you with expertise and required forms to help you navigate hiring both employees and independent contractors like a pro.

 

Author Bio

Jeffrey Bumbales
Director, Marketing & Strategic Partnerships