Compare Small Business Loans
Workers who receive a paycheck from a business are classified based on their contributions to the company. This classification determines what IRS forms you need to complete, as well as the payroll taxes you owe as a business owner.
When you hire an employee, you will file a W-2 form to report their wages, tips and other compensation, classifying them as a W-2 employee. The form will also report the employee’s withholding information, such as Social Security taxes.
An independent worker is classified as a 1099 contractor because business owners use a 1099-MISC form to report the payments that contractors receive. A 1099 contractor is someone you hire for a specific period or task rather than an employee. Although you can renew a contract for a 1099 worker, they wouldn’t continuously stay on your payroll as an employee would.
Incorrectly classifying workers could lead to trouble with the IRS, including potential tax consequences for both your business and workers. Continue reading to understand the difference between 1099 contractors and W-2 employees, and avoid confusion when designating employee status.
What is a 1099 contractor?
Independent contractors and self-employed workers like freelance writers and consultants who are hired to complete specific projects receive a 1099-MISC form each year from businesses if they were paid at least $600 during the tax year.
Contract workers need to pay income taxes on the amount that is reported on the form. They must pay taxes on all income received throughout the year from various businesses. Independent contractors are also subject to self-employment taxes, which include Social Security and Medicare contributions.
Business owners must give contractors freedom to complete their work independently. You cannot ask contractors to follow a set work schedule or dictate how a contractor completes their tasks.
When you hire a contractor, they need to fill out a W-9 form, which requires their Social Security number or taxpayer identification number. You will need this information when generating a 1099 form, so you should keep a contractor’s W-9 in your records.
You are not responsible for paying payroll taxes on behalf of a 1099 contractor. You just need to file the 1099 so that the contractor can pay taxes on the wages they received.
What is a W-2 employee?
Employed workers receive a W-2 form from their employer each year. The form discloses wage and salary information, as well as the amount of federal, state and other taxes withheld during the year.
Employees need their W-2 forms when preparing their annual tax return. Business owners must send out the forms no later than Jan. 31 each year.
When you hire an employee, they need to complete a W-4 form to indicate how much payroll tax to deduct from their pay. You are responsible for remitting the withheld amount to the IRS throughout the year.
A W-2 employee can be a full-time or part-time worker and could receive access to additional benefits like health insurance or an employer-sponsored retirement plan. But you are not required to provide those perks to employees.
1099 vs. W-2: What’s the difference?
|Required IRS form||W-2||1099|
|Tax responsibility||Employment tax withheld from employees’ paychecks||Self-employment tax (quarterly payments of Social Security and Medicare contributions)|
|Access to workplace benefits||Yes||No|
The main difference between a 1099 worker and a W-2 employee is tax withholdings. Business owners withhold taxes on behalf of employees, which is shown on W-2s. But independent contractors must estimate and pay their own taxes based on the income that’s reported on the 1099.
Your expectations would also determine the classification you choose. The IRS encourages business owners to classify workers based on how involved they plan to be in the relationship. The IRS provides three categories to consider when hiring workers.
If you hire an employee, you have the right to dictate how work is performed. You are allowed to give instructions on when and where employees should work, and what supplies and services they can use. Consider these other behavioral questions when choosing between an employee and a contractor:
- Would you provide detailed instructions? If so, you should hire an employee. Contractors are given more freedom in their work.
- Would you want to evaluate performance? If you want to assess the methods of how work is done, hire an employee. If you want to evaluate the end result alone, a contractor may be a better fit.
- Would you provide training? An employee would receive workplace training, while a contractor would be allowed to follow their own procedures.
Business owners have more control over the financial aspects of an employee’s job compared with a contract worker. Several monetary factors would impact whether you hire an employee or a contractor:
- Would you reimburse expenses? An employee typically receives reimbursement for work-related expenses, while a contractor often does not.
- What is your planned method of payment? You would need to grant an employee a regular wage at an hourly or weekly rate. A contractor would accept a flat fee to complete the assigned tasks.
- Can workers earn money elsewhere? An independent contractor would be permitted to seek additional business opportunities, while an employee may not have the same freedom.
A worker’s classification would determine their relationship with you as the business owner. An employee would expect some permanency in the relationship, while a contractor would expect interactions to end after a specific period of time. The classification would impact other aspects of the business relationship:
- Are benefits available? Business owners usually provide benefits, such as health insurance, vacation pay or a pension plan. Contract workers do not have access to those same benefits.
- How important is the work to the business? An employee’s efforts would be considered a key part of regular business operations, while contract work is usually supplementary.
Choose the right employee classification
Before hiring an employee or a contractor, think about how you plan to interact with the worker and what benefits and services you would provide on behalf of the business. Also, consider your tax responsibilities when classifying workers.
If you prefer more interaction with workers and are comfortable withholding and remitting payroll taxes, you may want to hire an employee. But if you do not want the responsibility of handling payroll taxes and would rather not manage a worker, an independent contractor could be the right choice.
Misclassifying workers can lead to consequences with the IRS. Classifying someone as a contractor without a solid reason for doing so could make you responsible for employment taxes. To avoid paying employment taxes, you would need to explain why you are not treating a worker as an employee based on the IRS guidelines.
If a contractor believes they have been incorrectly classified and should be an employee, they could report your share of uncollected Social Security and Medicare taxes to the IRS.
You could be held responsible for failing to pay overtime or minimum wage under the federal Fair Labor Standards Act, as well as under state laws. The U.S. Department of Labor and state labor departments could seek back payments on unemployment insurance and workers’ compensation insurance, and both organizations could require you to pay back wages to workers, as well as fines for improper record-keeping. The IRS may seek back taxes and possibly a criminal conviction, which could land you in jail or result in a large fine. Misclassifying an employee can also impact your company’s health insurance premiums.
Investing the resources in a W-2 employee may be out of reach for your business, especially if employees are not essential to your operation. You could hire a 1099 contractor to perform specialized tasks on an as-needed basis and avoid keeping someone on your payroll.
The IRS’ Small Business and Self-Employed Tax Center provides resources to help business owners classify workers and determine their tax obligations. You could also consult an employment attorney or certified public accountant if you have questions. Properly classifying employees and contractors could save you from penalties and fees from the IRS and others, so consider carefully what type of workers you need for your business.