Business Structure

1099 vs W-2 Employees

Understanding the differences between 1099 and W-2 employees is crucial for businesses. Let’s explore the key distinctions between the two.

Tax forms can be confusing at the best of times. And it can get even worse if you rely on a mix of independent contractors and full-time and part-time employees! As tempting as it can be to gloss over these forms or to 'fake it til you make it', you have to have a basic understanding of the rules when it comes to employee compensation, even if you have a bookkeeper helping you out. 

Whether or not someone is classified as an employee or an independent contractor is going to affect you and how you are taxed. Knowing the difference will also help you make smarter hiring decisions down the road. Let's dive in.

Independent Contractors vs Employees

An independent contractor is someone who works for themselves. When you hire an independent contractor, you make an agreement or contract with them to perform a specific job or task. Contractors usually have the freedom to set their own working hours and use their own tools. In fact, they may even work for multiple businesses at the same time. Since independent contractors are self-employed, you don't withhold taxes from their paychecks as you do with employees. They are responsible for paying their own taxes and providing their own benefits. 

An employee is someone who is hired by your business under an employment agreement. When you have employees, you take on more responsibilities. You provide training, pay employment taxes on their behalf, and offer benefits such as health insurance or retirement plans. As an employer, you have more control over your employees. You can set guidelines and rules regarding how and when they work. 

You could say that the main difference between independent contractors and employees is the level of control and responsibility you have over them. Independent contractors are self-employed and provide their own tools, set their own hours, and handle their own taxes. Employees, on the other hand, work under your business's employment agreement, and you have more control over their work and provide them with certain benefits. 

Tax Forms For Different Classifications 

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You are probably going to come across two different tax forms for employees and contractors: W-2 and 1099-NEC. 

The W-2 form, also known as the Wage and Tax Statement, is a document provided by an employer that shows how much money the employee earned, the benefits they received, and the taxes that were taken out of their paycheck during a specific tax year. Basically, it's a record of their compensation and taxes withheld. You should provide a W-2 if your worker is classified as a part-time or full-time employee at any time during the tax year. 

An employee must receive a W-2 if they were paid at least $600 in cash or cash equivalent during the year, including taxable benefits. Even if an employee earned less than $600, if any income, Medicare, or Social Security taxes were withheld, the employer must issue a W-2 to the employee. 

Now, let's talk about the 1099 or the 1099-NEC form. This form is used to report payments made to non-employee workers, such as independent contractors. If you hired someone to do a job or provide a service for your business and they are not classified as an employee, you'll need to issue them a 1099-NEC form. This form shows how much you paid them during the tax year and any taxes that were withheld (although it's likely that no taxes were withheld since they are not an employee). 

In summary, you file a W-2 for employees, while you file a 1099-NEC for non-employee workers like independent contractors. The W-2 reflects your earnings as an employee and the taxes withheld from your paycheck, while the 1099-NEC is used to report payments made to independent contractors who are responsible for handling their own taxes.

How To Find Out Whether Someone Is an Employee or a Contractor 

Many small businesses nowadays are hiring contractors instead of full-time employees because there are clear benefits to using them. Since you don't have to pay employment taxes or provide benefits for them, contractors often end up costing less than hiring full-time employees.

The IRS says there isn't a clear formula for determining whether or not someone is an employee or a contractor, but it does provide guidelines to help classify workers as either 1099 contractors or W-2 employees. There are three things to consider: 

  • Behavioral: Do you control how the worker does their job? If you have significant control over things like their work schedule, location, tools they use, and the methods they use to complete tasks, they are more likely to be classified as an employee.

  • Financial: Do you control the business aspects of the worker's job, such as how they are paid and whether they can seek additional work elsewhere? If you have control in these areas, it's more likely that the worker should be considered an employee. 

  • Type of relationship: Do you provide benefits like insurance or paid time off? Is the job expected to be ongoing or indefinite? Are the services provided by the worker a key aspect of your business? If any of these apply, it's possible that the worker should be classified as an employee. 

It's important to note that simply having a contract stating the worker is an independent contractor and responsible for their own taxes is not enough to determine their classification. The IRS looks at the actual working relationship to make the determination.

Why It's Important To Classify Workers Correctly 

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Proper classification of workers is crucial because misclassifying employees can lead to costly penalties and legal issues that nobody wants to deal with. 

Employee misclassification occurs when workers are mistakenly labeled as independent contractors instead of employees. If you misclassify employees, you may fail to pay unemployment and other required taxes, and you may not provide workers' compensation and unemployment insurance when you should. 

If the IRS discovers that you have misclassified employees, you may be required to repay all the taxes and benefits that you should have been providing. This can include reimbursing employees for wages they should have received, paying back taxes and penalties, or even paying the employee benefits that you should have provided to begin with. 

You might even have to be required to provide employee benefits like health insurance and retirement plans that you should have been offering all along. Suffice to say, it's an expensive exercise, which is why you need to nail this down from the start. 

In the realm of W-2 employees, you can find individuals like staff writers who have set hours and consistently work on assigned tasks. Project managers also fall into this category, as they have ongoing responsibilities and participate in regular team meetings. 

Delivery drivers who follow scheduled routes, utilize company vehicles, or display company signage, can be considered W-2 employees. Staff designers or developers who have designated hours, whether they work remotely or in an office, and engage in ongoing projects, are also classified as W-2 employees. 

1099 workers have a different set of roles. Freelance writers, for example, operate on an assignment basis, taking on projects without being tied to specific working hours. Consultants offer their expertise and support to your company for projects with a clear start and end date. Freelance designers and developers work on a project or assignment basis, providing their skills and services as needed. The common thread, in this case, is a high degree of autonomy over their work.

Differences Between W-2 and 1099-NEC 

If you hire someone as an employee, you'll need to provide them with a W-2 tax form. This form is used to report the annual compensation paid to employees and the payroll taxes that were withheld from their earnings. Employees who receive a W-2 are typically paid through the employer's payroll system, and their payroll taxes are deducted throughout the year. Employers are required to send W-2 forms to their employees by January 31 of the following year. You can find the W-2 form on the IRS website, and some payroll systems like Square Payroll can also help generate and file W-2 forms for you. 

When you have W-2 employees, you are responsible for withholding part of their Social Security and Medicare taxes from their wages and paying a matching amount yourself. This includes federal and state unemployment taxes, Social Security taxes, and Medicare taxes. When you work with independent contractors, you generally don't have to withhold or pay any taxes on their payments.

In reality, there is no such thing as a "1099 employee." The term is often used to refer to a contractor or freelancer who receives a 1099 form for their work. These individuals are not full-time employees but rather independent contractors. As a business owner, it's important to understand the type of work these individuals will do for your business and what your responsibilities may be, such as reimbursement or benefits. While contractors are not typically entitled to the standard benefits provided to full-time employees, as an employer.

When it comes to hiring independent contractors, you'll need a 1099 form. Specifically, the 1099-NEC form is used to report payments made to independent contractors throughout the year. If you paid an independent contractor $600 or more in a calendar year, you are required to send them a completed 1099-NEC (Copy B) by January 31 of the following year. However, there are exemptions for certain independent contractors, such as corporations, that may not require reporting. You need to file the 1099-NEC (Copy A) with the IRS by January 31. You can obtain hard-copy 1099-NEC forms from the IRS or use platforms like Square Payroll to generate and file them electronically. Businesses that file more than a total of 10 forms W-2 or any combination of 1099s must file electronically. 

It's worth noting that if you file any 1099-NEC forms, you'll also need to fill out Form 1096, which provides a summary of all the 1099s you prepared, and submit it to the IRS by January 31. Form 1096 is submitted regardless of how you file (electronically or physically).

Transitioning Between The Two 

If you're considering transitioning your contractor to a full-time employee, there are a few things to keep in mind. First, you'll need to have an open position within your company that aligns with the contractor's skills and responsibilities. This means you'll go through the standard hiring process, including job postings, interviews, and making an official offer of employment.

On the other hand, converting an existing employee into a contractor can be a bit more complicated. The default assumption is that workers are considered employees unless there is clear evidence to prove otherwise. If you switch someone from being a W-2 employee to a 1099 contractor, it might raise questions from the IRS. It's important to consult with both a lawyer and an accountant to ensure you understand the legal and financial implications of such a change. They can guide you through the process and help you determine the appropriate steps to take. 

Final Thoughts 

Payroll taxes and employee classification can be a minefield if not done correctly. You could leave yourself open to all kinds of penalties from the IRS, as well as a heap of paperwork. (Not to mention damaging relationships with the people you depend on to get the job done). 

If you aren't sure how to classify workers, how to complete forms, or even which hiring decisions to make, get in touch with LedgerFi. We have a team of certified tax professionals who can answer every question you may have about employees or contractors, including tricky questions about tax liabilities and obligations. 

Why leave things to chance? Speak to LedgerFi!

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