1099 vs. W-2 employees: What you need to know before you hire

By January Colandrea

Taking the leap as a business owner can be both challenging and rewarding. Many people start businesses to be self-employed and take control of their own destiny. If you’re a new business owner, you may not have realized how much responsibility you have as an employer on the financial, legal, and tax fronts.

As a new small business owner, you may find yourself hiring both full-time employees andindependent contractors to help you achieve your business goals. If you already employ both types of workers, thenyou have a serious responsibility to understand the financial, legal, and tax consequences of each.

Consequences of 1099 vs W2 classifications

Full-time employees are issued a tax Form W-2 every tax season. The W-2 form from an employer shows how much federal and state taxes were withheld throughout the tax year. As a result, W-2 employees usually receive a tax refund every year.

Independent contractors, on the other hand, don’t usually receive as many benefits as W-2 employees, such as taking part in a company’s retirement plans, having paid-time off, or receiving health insurance. Usually, contractors are responsible for providing those benefits for themselves.

Independent contractors don’t have tax withholding. They are especially responsible for payingself-employment taxes that cover both Social Security and Medicare tax. Contractors receive a Form 1099-MISC,essentially showing how much was paid to them from a business throughout the duration of their contract.

As a business owner, you need to understand the differences between an employee and anindependent contractor because it affects how income taxes are withheld and paid. It not only affects your taxliability but can save you from legal trouble.

If an employee is misclassified as an independent contractor, you could be subject to costlyfines and legal fees. W-2 employees who are misclassified as independent contractors can take legal action againstyour business for benefits they were denied, such as health insurance and overtime pay.

Here are the differences between the two types of workers.

W-2 Employees

W-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 Contractors

Independent 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 contractors

You’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?

The level of control that a business has over the worker really distinguishes between the twotypes of workers. If the person’s work is directly controlled by the business in terms of how they perform the job,then the worker is most likely a W-2 employee.

If the person has a greater degree of control and autonomy, then they’re most likely anindependent contractor.

Why you should learn the differences

Many businesses are agile with the type of employees they hire. Some only hire full-timeemployees, while others hire independent contractors. Then there are businesses who employ both.

When hiring, it’s extremely important, as a business owner, to know the differencebetween hiring full-time employees and independent contractors. It’s important not only from a financialperspective but from a legal perspective.

Make the distinction before you hire to save you from legal trouble later on. Outline thescope of work and how the work is done in a conversation with the prospective employee.

As a business owner, you also have to understand what your needs are. Are you hiringsomeone to help you perform tasks on a day-to-day basis with a set schedule? Or, are you hiring someone for aset period of time, using their expertise to get a specific job done?

These questions can help you make the distinction between 1099 and W-2 workers.

Manage 1099 contractors

1099 vs W-2

Log completed work

Separate vendor expenses

Prepare tax forms

Conveniently e-file online

Print and mail 1099 forms

1099 vs. W-2 employees: What you need to know before you hire

W-2 Employees

1099 Independent Contractors

Determining whether your workers are employees or contractors

Why you should learn the differences