Correctly classifying workers and submitting the appropriate information return can help keep your business compliant with IRS rules. It’s important to understand the difference between a W-2 and a 1099 since both types of workers receive different tax forms.
Employees get a W-2 form, while independent contractors get a 1099 form each year. Understanding the key differences between these classifications will help your business avoid costly mistakes at tax time.
Payroll Taxes
The way you pay your workers impacts how they pay taxes. If you hire someone as a W-2 employee, you must withhold federal income tax, social security, and Medicare from their paycheck. On the other hand, you don’t need to withhold these taxes from wages for 1099 workers because they settle their taxes.
It’s important to have clarity before hiring new staff members because misclassification can lead to expensive penalties from the IRS. To avoid this, you can consider three categories of facts when determining the difference between 1099 and W2.
For example, W2 employees must be hired indefinitely to perform consistently required work and are expected to meet your company’s standards and policies. In contrast, a 1099 contractor is a self-employed individual who decides on their working hours and may work for multiple businesses simultaneously. Independent contractors also don’t need to be supervised by a team leader and can make decisions independently without your input.
W2 employees receive a W2 form each year that details the wages earned during the previous year and the amount of taxes withheld. On the other hand, 1099 workers must complete a W-9 form and 1099-MISC each year to report the amount of money they received from your company during the previous year.
Benefits
Employees who work for your company receive W-2 information returns from the business each year, detailing the amount of money they earned during that calendar period and the federal income tax withheld. Employers must also pay social security and Medicare taxes on the wages of W-2 employees, equaling 7.65 percent of their total earnings. However, independent contractors must pay their self-employment taxes, which total 15.3 percent of their income.
As a business owner, understanding the differences between 1099 and W-2 workers is crucial to avoid costly mistakes such as misclassification. Incorrect classification can result in substantial penalties from government agencies. For instance, the IRS can issue back taxes and fines to businesses that have improperly classified their workers as W-2 or 1099 employees.
While each type of worker offers distinct benefits, some companies may prefer one based on their unique needs. For example, full-time W-2 employees are a great fit for businesses that need consistent and reliable assistance with day-to-day operations.
On the other hand, businesses that need to fill more temporary gaps in their workload should consider hiring 1099 contractors. In addition to their lower costs, these workers provide more flexibility to meet the demands of your clients. Moreover, contractors can help your business grow faster by introducing new ideas and approaches to a project.
Taxes for Self-Employed Individuals
The difference between W2 and 1099 workers is more than just payroll taxes. Workers for hire that receive W-2 forms get taxed on their wages according to the federal income tax withholding schedule. Those hired as freelancers, independent contractors or non-payroll employees do not get this tax treatment. They must track their earnings, estimate how much they owe in self-employment tax and make estimated payments throughout the year.
Whether your company should employ W2 or 1099 workers depends on the current business needs, talent and strategic objectives, and budget. Generally, it’s more cost-effective to have full-time employees, but you might need to recruit freelancers or other 1099 workers for their expertise, speed and agility.
The IRS requires businesses to send a 1099-MISC or 1099-NEC form to all nonemployees who earn at least $600 in a given tax year. These forms list their compensations and any federal, state and local taxes withheld (likely none). The newer 1099-NEC form came into effect in 2020 and simplifies filing deadlines by allowing companies to report all payments made to nonemployees on a single form. Moreover, the new form also allows you to clarify the definition of income for purposes of self-employment tax, which is applied at a rate of 15.3%. Only net business income — total earnings minus any allowable expenses — is subject to the self-employment tax.
Misclassification
Businesses must understand the ramifications of different tax forms for their workers, whether W-2 or 1099 employees. More than correctly determining worker status can result in significant financial penalties from the IRS. To avoid misclassification, you should regularly evaluate each worker’s level, determine their degree of control and document how you make your classification decision.
Regarding wages and salary, the primary distinction between W-2 and 1099 workers is their level of direct control over their tasks. If you have a W-2 employee, you must report and withhold federal income tax, wage garnishment, salary reduction amounts for contributions to the 401(k) or other employee benefit plans, and social security and Medicare taxes.
With 1099 workers, on the other hand, you will only need to report and withhold income tax from their payments for services rendered. However, you may still be required to pay your share of FICA (Social Security and Medicare) taxes.
If the work you need to perform is core to your business – like marketing, client relationship management or any managerial roles – hiring a W-2 employee may make more sense from a long-term and work culture perspective. Likewise, if the work you need to perform is non-essential or seasonal, hiring a 1099 employee could be more cost-effective and less of a regulatory burden.