What's the difference between a 1099 and a W2?

The benefits, disadvantages, and legal differences between these groups can be confusing, and the penalties for business owners that misfile adds to the intimidation. We'll cover the differences between 1099 and W2 forms.

As the workplace has evolved, so has the type of workers it employs. Most people have heard of independent contractors, especially as the gig economy has grown. According to the ADP Research Institute, since 2010, the number of independent contractors has grown a 2.2 percentage point increase, or by 15%. This change means that companies who traditionally have had W-2 based employees are starting to learn about the advantages of 1099 workers, also known as independent contractors, freelancers, or gig workers. The benefits, disadvantages, and legal differences between these groups can be confusing, and the penalties for business owners that misfile adds to the intimidation. We'll cover the differences in these forms and the corresponding employment types.

What is a 1099?

A 1099-NEC form (formerly called a 1099-MISC form) is a tax form sent to self-employed contractors if they are paid $600 or more during the tax year. Examples of independent contractors include freelance writers, independent graphic designers, and some consultants. There are a few exceptions to this, such as for some corporations treated as c-corporations or s-corporations. There are also 1099-K forms for payments made through credit cards, third-party transactions, and other methods.

1099: The basics

If you're hiring an independent contractor, your company will handle tax withholdings much differently. A 1099 worker is considered self-employed and often employed on a contract basis for specific tasks. How they interact within the company and their work are decided within that contract and can vary depending on the role you want them to fill. Regarding the form itself, it is necessary in part because independent contractors withhold their own employment taxes since they are self-employed, not an employee of your company.

When is a 1099 appropriate?

From the IRS perspective, independence and degree of control over the employee determine whether a 1099 or W-2 is more appropriate. While this is up to interpretation, the IRS website covers three key items to consider which employee type is more appropriate.

1. Behavioral. Does the company control, or have the right to control, what the worker does and how the worker does his or her job?

For a 1099 worker, their independence is often confirmed through the contract you sign with them upon hiring. Usually, they don't have nearly the amount of instruction as a regular employee, as they only create a product or provide a service by a certain deadline. This structure means they often work where and when they want to and are not usually trained by the company.

2. Financial. Are the business aspects of the worker's job controlled by the payer? (these include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)

This one can be confusing. Independent contractors often pay for all of their equipment, such as a home office, and are more likely to have unreimbursed expenses. These workers are also usually free to work at multiple establishments simultaneously and are not guaranteed a regular hourly or weekly wage.

3. Type of Relationship. Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue, and is the work performed a key aspect of the business?

These freelance workers often have a contract stating they are an independent contractor, and these deals often don't include employee benefits. When hired as an independent contractor, there is most likely not an expectation of permanency, and the services are not a key business activity.

What is a W-2?

A W-2 form is required for all typical business employees and shows an employee's salary information along with federal and state income tax withholdings.

W-2: The basics

When you onboard a long-term employee into your company and withhold income, social security, or Medicare tax, you will need to fill out a W-2 form for them. This form is also known as the Wage and Tax Statement. They are also used to report FICA taxes for employees throughout the year.

When is a W-2 appropriate?

Opposite of the 1099 independent contractors, a W-2 is most appropriate if the employee has less independence from your organization. For instance, these workers often follow a company policy regarding hours and where they are allowed to work. They often are given benefits such as health insurance and are provided the entirety of the equipment they may need to work. The position is also usually assumed to be a long-term assignment, and they receive regular paychecks.

How independent contractors differ from employees

Sometimes, you may need an expert to help you with one task or project. For example, you might need a graphic designer to create a few graphics for your new website. When this is the case, rather than onboarding them as a W-2 employee with regular hours, full benefits, a space in your office, and other traditional employee items, it can be much more advantageous to hire them as a contractor. If you know you will need this worker on a very temporary basis or sporadically, it can be beneficial to both parties to come to a different agreement through a contract.

Unlike typical employees, independent contractors usually have a short-term contract in which their employment's legal considerations are detailed. Employees work under a company policy that often is more strict in dictating how the organization expects them to do their work, however they also receive benefits and usually have a long-term planned position within the company. They pay for their own income tax withholding, such as social security tax.

Choosing employees or contractors

There are pros and cons to hiring contractors over employees. Contractors are often skilled in their craft, making them an efficient option for resolving a short-term need like writing or consulting. Independent contractors withhold their own taxes, so you are not required to manage their payroll taxes or pay them benefits, leading to financial savings. These workers often need minimal direction and little to no resources from the company to complete their tasks.

On the other hand, training a full-time employee to do what you would hire a contractor for can be a monetary and loyalty benefit for the firm in the long run. You have more control over employees, while you only have the rules dictated in the contract with an independent contractor. Legally, things are more complicated when hiring a freelance worker as workers' compensation does not cover them, and you may not be able to fire them at will depending on the contract, along with other technicalities.

Overall, what worker classifications are best for your company depends on your needs and the specific project you are looking to accomplish. Whether you are a small business owner or just learning about employee misclassification, you can always take a look at the IRS guidance website for more information on the categories. They also have an SS-8 form or Determination of Worker Status form that you can fill out if you are still unsure, though these can take quite a bit of time to be processed. It is always recommended to reach out to an employment expert when trying to make these decisions if you have any doubts.

If you're looking for a solution to pay your independent contractors, Routable can help. Routable is a simple way for companies to send payments.

This post is intended for informational purposes only, and should not be taken as tax, accounting, or legal advice. Laws may vary by state or location. For specific advice pertaining to your business, please consult a CPA, tax, or legal professional.