1099 vs. W-2 Employees

The difference between a 1099 employee vs. a W-2 employee goes beyond their tax forms. The distinction shapes how much control you have over an employee, your financial responsibility towards them, and your tax obligations. 

Even if you have a third party handling your books, it’s essential that you know the differences. It will help you make the best employment decisions for your business.

What’s a 1099 worker?

A 1099 worker is an independent contractor. An independent contractor has more control over their work, is generally paid by the hour or per assignment, and is responsible for paying their own taxes, business expenses, and benefits. They often have specialized expertise and are brought on board for a specific project or function. The Internal Revenue Service (IRS) considers independent contractors and freelancers who provide their services to businesses to be self-employed. 

Examples of 1099 workers are: 

• Freelance graphic designers, software developers, and writers who work on an assignment or project basis 
• Business consultants or professionals bought on for special projects with defined start and end dates
• Gig workers like Lyft drivers and Airbnb hosts
• Virtual assistants or transcribers who provide services through an app  

What is a W-2 employee?

Simply put, a W-2 employee is your regular part-time or full-time employee. They are on the employer’s payroll and automatically have their payroll taxes withheld.

Other characteristics of W-2 employees are:

• Hired for an indefinite time period with well-defined duties and hours
• Have employee benefits like paid time off and health insurance
• Carry out job duties determined by the business
• Receive a W-2 form at the end of the year that summarizes their earnings and deductions

For a W-2 employee, a business has to withhold applicable state and federal taxes, pay employment taxes, and contribute to their Social Security and Medicare funds.

Examples of W-2 employees are:

• Department managers who complete required daily tasks and are given company computer
• Executives and management teams
• Hourly employees with fixed hours who receive annual training
• Designers, developers, and writers who have set hours and continuous work 
• Administrative staff with set hours and receive company-sponsored medical plan

Employee agreements vs. independent contractor agreements

Signing employment contracts is a smart way to set expectations and limit your liabilities. However, don’t assume all employee contracts are the same. A fundamental difference exists between an employee agreement and an independent contractor agreement. 

An employee agreement is for part-time and full-time employees on the company’s payroll. Elements included in an employee agreement are job expectations, working conditions (locations, hours, days), compensation and benefits, termination terms, and details about the severance package. Many employee agreement contracts also have nondisclosure, non-compete, and overtime payment clauses.

An independent contractor agreement has some overlap with an employee agreement, such as the inclusion of payment terms and role responsibilities. 

But, an independent contractor agreement will also include: 

• Specific details about the project or task
• Project start and end dates
• Nonsolicitation terms 

It won’t include information about severance pay, overtime pay, benefits, or contributions to retirement accounts. 

An experienced attorney can help you draft a contract tailored to an employee or independent contractor. They will ensure you don’t miss out on crucial elements like confidentiality or nonsolicitation clauses that can harm your business down the road. 

1099 employee vs. W-2 employee key differences

The difference between a 1099 worker and a W-2 employee boils down to four things: employment status, taxes, benefits, and costs. 

Employment status and working relationship

The main difference between the two types of workers is their relationship with the hiring authority. A W-2 employee is legally part of your company’s staff count, and you can control the work performed, working hours, and location, and mandate the use of specific tools. 

You can’t enforce the same control over 1099 workers because they are self-employed, independent contractors. They set their own hours, accept or decline assignments, and use their own tools and methods. They can also decide to provide their services to other businesses.

Employment taxes

For a W-2 employee, the employer must withhold state and federal income taxes and Medicare and Social Security taxes from their pay. An employer must also report and pay unemployment tax for each W-2 employee. 

On the flip side, no taxes are withheld for 1099 workers. Self-employed workers are responsible for reporting payments and paying income and self-employment tax (which covers Social Security and Medicare taxes).

Here’s an example: You hire John as a freelance designer for your website and onboard Mary as a full-time administrative assistant. When John completes his design assignment, you will simply cut him a check for his fees without tax cuts. But, for Mary, you will withhold taxes like income, Social Security, and Medicare taxes from her paycheck each payday. At the end of the tax year, it’s your responsibility to pay these taxes to the appropriate government agencies on Mary’s behalf.

Benefits and protections 

W-2 employees have access to a plethora of benefits and legal protections. They are guaranteed minimum wage and stand to receive employer-provided benefits like health insurance, dental insurance, paid time off, and retirement saving plans. 

Other perks and legal protections afforded to W-2 employees are: 

• Overtime pay (for those who qualify)
• Unemployment benefits if laid off
• Workers' compensation if injured on the job
• Right to join a union (depends on industry)
• Family and medical leave to care for family members or bond with newborn child
• Protection from employment discrimination based on gender, age, origin, color, and religion 

A 1099 worker is on their own when it comes to benefits and legal protections. They are 100% responsible for their Medicare and Social Security taxes, insurance, injuries, and retirement plans. They don’t get any paid time off or unemployment benefits. 

Costs

The Small Business Administration (SBA) says that hiring an employee actually costs approximately 1.4 times their salary. Workers’ compensation, paid time off, insurance, payroll taxes, supplies, equipment, training costs, and more drive up the overhead expenses for W-2 employees.

A contractor's hourly rate tends to be on the higher end of the salary spectrum, but remember they are not employees and don’t come with other costs like administrative expenses. You don't have to pay for unused vacation days or spend on their training. Therefore, your business can save at least 20-30% if you hire contractors to complete tasks.

Misclassification of employees

Picture this scenario: You thought you were saving money by hiring a freelance writer for your company’s blogs, but you gave them set hours and mandated they complete tasks from your company’s location. Come tax time, you get a fine because you misclassified the employee as a contractor. The savings have turned into a headache. 

If a small business misclassifies a worker, they could be on the hook for:

• Unpaid employment taxes like Medicare and Social Security taxes
• Unemployment insurance
• Pay if minimum wage wasn't met
• Unpaid overtime

Worker misclassification doesn’t just impact the business owner. It affects the employee, too. If we go back to the above example, the freelancer misses out on workers’ compensation and unemployment benefits because the government didn’t receive the employer’s share of the taxes. A W-2 employee misclassified as a worker doesn't receive the legal protection afforded to other employees. 

Appropriate classification is not just about avoiding fines or criminal penalties from the IRS. It’s about understanding your working relationship with your people and the rights and protections afforded to each type of employee. A tax or legal consultant can explain the range of risks associated with misclassification of a worker.

Which classification should you choose?

Contractor relationships or employees? Consider the following factors before you decide to hire one over the other.

1099 employee vs. W-2 employee: How to choose

Carefully weigh the following considerations to determine which option suits your needs. 

• Fluctuating workload: If your business has a fluctuating workload, it's better to hire a contractor. Bring them on board as required, and you can let them go when the task ends. There’s less chance of facing legal troubles associated with firing and laying off W-2 employees. 
• Schedule and location: If your business thrives on a set schedule and daily routine or requires work done from a specific location, an employee might be the better fit. They can integrate seamlessly into your existing structure.
• Work oversight: Consider the nature of the work itself. Does the worker's job require constant supervision? Tasks that require direct guidance, like developing a new chemical with frequent testing, benefit from having an employee on board as you can monitor progress closely.
• Quality control: If the selling point for your business is product quality, it's better to hire a W-2 employee. They offer more stability and can help you create a consistent, high-quality customer experience even as you expand.
• Urgency: If your work is time-sensitive and time-bound, an independent contractor can jump right in and get things going. Onboarding an employee takes longer.
• Talent availability: In certain technical fields, finding full-time employees is harder. Working with a contractor can give you access to specialized expertise. For example, you can bring on a carbon expert to design one part of a machine for your line instead of burdening your engineering team. 
• Company culture and loyalty: Fostering a company culture with contractors rotating in and out is more challenging. If establishing a sense of team, collaboration, and loyalty is crucial to your business’s success, hiring a W-2 employee is a better choice. 

How to classify workers

The lines between a W-2 employee and a 1099 worker can be confusing because no single test applies. The Internal Revenue Service has a three-point common law test (guidelines) that can help you avoid lawsuits and penalties. 

The IRS examines the entire relationship between a business owner and the employee, focusing on three key factors: behavioral control, financial control, and type of relationship.

• Behavioral control. This refers to how much control your business has over work performed by the employee and factors in details like how, when, where, and what work is completed. Let’s say you trained an independent contractor, gave them a three-page instruction guide, and specified performance measurement metrics, you'll have to classify them as an employee.
• Type of relationship. What's the working relationship between your business and the worker? Does a written contract with a defined start and end date exist between the two? Are you providing employee-type benefits like overtime pay or paid holidays? A long-term contract with ongoing work and no end date or timeline leans towards classification as an employee. 
• Financial control. Does your company control the worker's financial and business aspects? The more control a business has over the person's finances and work style, the more likely they are to be considered an employee. In deciding, "Are the financial aspects of the worker's job controlled by the company?" the IRS will look at:

1. Payment methods: Employees are guaranteed minimum wage or a salary amount, while independent contractors are paid a flat fee per job or by the hour.
2. Coverage of business expenses: Independent contractors are responsible for their own expenses, which they can then deduct as business expenses for tax purposes.
3. Amount of tools and resources provided to the worker: Independent contractors generally use their own materials to complete assignments.

Using the IRS three-point test to determine a worker’s classification, but are still confused? An experienced attorney will examine your entire relationship with the worker and advise you on classification.

FAQs

Can a worker be both a 1099 employee and a W-2 employee?

As per the IRS, a worker on your payroll who provides a different set of services can be counted as a W-2 and 1099 worker. The key aspect here is a distinction of service. A valid example of this would be an administrative assistant on your payroll who is contracted to perform pest cleaning services after hours.

Does a 1099 employee pay taxes?

Independent contractors must uphold their tax obligations and pay self-employment and income tax.

How does a business report payments to independent contractors?

For federal tax purposes, you can use IRS form 1099-NEC to report wages paid to a service provider. You don't have to withhold income tax or the employee's share of employment tax.

What is the deadline for filing a 1099 and a W-2?

January 31 of the following year is the deadline for giving any service provider and employee their Form 1099 or W-2. For the wages paid in 2024, you have till January 31, 2025, to submit the documents. You must also submit a summary of all the W-2s and 1099s you prepared to the appropriate government agencies by January 31. If you miss the filing deadlines, you can request a 30-day extension using Form 8809. 

What happens if I misclassify a worker?

If you misclassify an employee as an independent contractor and have no reasonable basis for doing so, you could face civil fines or criminal penalties for failing to withhold state and federal taxes. You may also have to pay wage shortfalls and unpaid taxes.