1099 vs W-2: What’s the Difference?

1099 vs. W-2

1099 vs W-2: What’s the Difference?

IRS forms may be the last thing that you want to think about when you first start a business. However, if you need to hire employees, you will need to decide whether you want to hire an independent contractor or add an employee to your payroll. It is important for you, your payroll service, and your employees or contractors to understand where they stand. Otherwise, you may end up with financial penalties at the end of the fiscal year. Here’s what you need to know.

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.

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