W-2 EmployeesW-2 employees are typically salaried employees and don’t own their own business. They have anobligation toward your company and acting in its best interest. W-2 employees work according to your company’s schedule and participate in employee benefit programs. Their employment contract lasts for an undefined period oftime.When W-2 employees start a new job, they file an IRS Form W-4. The W-4 form outlines how muchyou, as an employer, can withhold in taxes.The more federal allowances (i.e. people to take care of in their household) an employeeoutlines in the form, the less the employer withholds. Consequently, the greater each paycheck is relative to taxes,potentially resulting in a lower federal tax refund at the end of the year. Fewer allowances result in more federaltaxes withheld, resulting in lower paychecks but greater tax refunds.An employer must withhold income taxes, withhold and pay Social Security and Medicare taxes,and pay payroll taxes and unemployment taxes on wages paid to an employee. As an employer, you must report thesetaxes to the Internal Revenue Service (IRS). The tax form you file is a Form W-2 and you file it on behalf of youremployees.Businesses pay a 15.3% FICA tax, which is used to fund Social Security and Medicare. Anemployee with a Form W-2 pays 7.65%, and you as an employer pay the other 7.65%.By law, W-2 employees are guaranteed at least a minimum wage, set by both federal and statelaws, for the time they’ve worked on an ongoing basis. Employers provide all the necessary tools and supplies forW-2 employees, and employees are typically reimbursed for business expenses they incur over the course of theiremployment.Benefits such as pension plans, profit-sharing plans, health insurance, retirementcontributions, and sick pay are available to all qualifying employees in a business.
1099 Independent ContractorsIndependent contractors are non-employees and tend to have a greater degree of control overtheir work product. Independent contractors only work on one project at a time, but many serve multiple clients.Contractors are brought on to provide a service within their expertise for a defined period of time. Classicexamples of independent contractors are consultants and freelancers. They are self-employed and take you on as aclient. So they’re business owners themselves.Unlike W-2 employees, businesses work with independent contractors for a defined period oftime, outlined by a written independent contractor agreement. A sample independent contractor agreement wouldinclude an effective date, project expectations, and an expected timeline. When contractors begin work, theyfill out a Form W-9, indicating their tax identification number (or social security number) and organizationalstatus (i.e. sole proprietor, trust or estate, C corp, S corp) to the IRS.This form indicates that you, the client, hired a contractor at one point throughout thecalendar year. You need this to issue 1099-MISC forms to any contractors you hired.The independent contractor agreement can be renewed as many times as the contractor and the business owner seefit. The terms of this agreement can be amended upon renewal. Where W-2 employees work according to yourcompany’s schedule, independent contractors define how and where they work, and can set their own hours.Contractors have the flexibility to hire their own workers (i.e. subcontractors) to helpthem deliver the product or service that you hired them to provide. They provide their own tools and supplies toget the job done.As a business owner, your level of financial and legal responsibility toward contractorsis low. Workers who have independent contractor status pay both employee and employer self-employment taxes. Acontractor with an IRS Form 1099-MISC is responsible for the full 15.3% of the “self-employment tax” and candeduct one half of the self-employment tax on their personal tax returns (Form 1040). Since a 1099 workerassumes the full self-employment tax, they will usually pay quarterly estimated tax payments.Because a contractor’s work is set for a defined period of time, if the contract is notrenewed for one reason or another, you’re not required to pay unemployment compensation or unemploymentinsurance. Independent contractors are also not eligible for the benefits you might offer your W-2 employees,such as 401(k) plans, pension plans, sick pay, health insurance, paid-time off, and overtime.Hiring 1099 workers is much simpler than hiring full-time W-2 employees. It begins withan agreement written and signed between a business and a contractor. The terms of this agreement outline thesalary, the dates of payment, and for how long the contractor is aligned with the business.If there isn’t a fit between your business and the contractor, the termination of thisagreement can happen at any time with no financial obligations (i.e. no need to issue unemployment payments andcoverage).
Determining whether your workers are employees or contractorsYou’re probably wondering why there are two types of workers anyway. Often times, it comesdown to cost and convenience. It’s much easier to pay a contractor than it is to administer payroll and benefits orhandle the other HR functions required of a business with employees.Contractors can charge more money, especially if the contractor is brought in for their uniqueexpertise to help on a project. In many cases, hiring contractors can cost more from a salary perspective sinceemployee-type benefits, like insurance coverage, are not provided.If the IRS or Department of Labor (DOL) audits you and finds out that you’ve misclassifiedworkers, then you will be subjected to severe penalties. The IRS can levy back taxes and penalties. The DOL can alsorequire you to pay wages going back three years if independent contractors have been misclassified.Although there is some guidance from the IRS about how to correctly classify your workers, werecommend you seek legal advice to best protect yourself.Here are three major considerations to help you determine whether workers are employees orindependent contractors:
- Behavioral: Does your company have the right to control what, where, when, and howthe worker does his or her job?
- Financial: How are you paying that worker? Is it a regular salary or a flat fee?Are expenses reimbursed? Who provides the tools and supplies to get work done?
- Type of relationship: Are there written agreements (i.e. contracts) outlining aworkers’ compensation or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Is theworker hired for an undefined amount of time or brought on temporarily?