The "gig economy" has fundamentally altered the shape of American commerce. As a result, over 58 million Americans now identify as independent workers. While many businesses enjoy using independent contractors, it is critical that they learn to distinguish between W-2 employees and 1099 workers for tax purposes.
Failure to correctly classify W-2 employees and 1099 workers can lead to legal or financial penalties. The differences between the two worker classifications are nuanced, which can make classifying staff members a challenge.
This guide explores W-2 employees, 1099 workers, how 1099s and W-2s impact payroll taxes, and other related topics. Read on to learn more about how your business should classify its workers!
What is a W-2 Employee?
The traditional definition of a W-2 employee is an individual formally employed by a company or organization in the United States. W-2 employees receive annual tax documents containing pertinent details about their earnings and deductions. Unlike 10-99 workers, W-2 employees are bound by a formal contract with their employer. This condition means these employees can benefit from various protections and occupational advantages. In addition to benefits, W-2 employees either receive a standard salary or an agreed-upon hourly wage.
Employers also set aside payroll taxes for W-2 employees. This reduces the tax burden for many W-2 employees by ensuring that they don't have to cover things like Medicare and Social Security taxes alone. However, it does create an administrative burden for employers, who must then deduct taxes on behalf of their employees.
W-2 benefits employers and employees. For employees, using a W-2 affords many businesses greater control over their workforce. Employers can carefully outline details related to hours, workplace procedures, and more. W-2 employees will typically be given an employee handbook that outlines the exact nature of their position and how to perform their assigned duties.
Remember: A W-2 is a tax form designated for domestic companies that employ individuals licensed to work in the United States.
What is a 1099 Worker?
A 1099 worker is another term often used to identify an independent contractor or freelancer. Unlike W-2 employees, 1099 workers do not receive employment benefits like sick pay or health insurance and, as such, do not have the same occupational responsibilities. What does this translate to? Essentially, it means that a 1099 worker cannot be held to specific standards regarding the terms of their employment.
At the end of each tax year, a 1099 worker receives a form detailing the full scope of their compensation. These workers also receive a 1099 form from each client for whom they freelance. While employers automatically take income taxes out of a W-2 employee's payroll, this is decidedly not the case with 1099 contractors.
Since employers do not contribute payroll taxes for workers on 1099 contracts, the worker must pay a 15.3% self-employment tax, which is then put towards Medicare and Social Security. As such, 1099 contractors miss out on advantages that W-2 employees enjoy, such as options for retirement and insurance plans.
What is the Difference Between a 1099 vs W-2 Employee?
Below are five critical differences between W-2 vs. 1099 employees:
- Employment status: Workers who sign a W-2 form are officially considered company employees. Workers signing a 1099 form are technically considered freelancers or independent contractors.
- Tax Forms: "1099" and "W-2" refer to specific tax forms. Which form you file will depend on the classification under which your work falls.
- Responsibilities: Since 1099 workers are technically classified as independent contractors, their employers cannot dictate the conditions under which they perform their duties. W-2 workers, on the other hand, are employees in the conventional sense of the term, meaning their bosses can demand that they work certain hours, etc.
- Tax Withholding: Regarding W-2 employees, businesses must automatically deduct and withhold income taxes as part of their respective accounting processes. 1099 contractors, meanwhile, are responsible for paying their taxes, which may require additional savings on their end. To estimate the difference between W-2 and 1099 taxes, use a 1099 vs. W-2 calculator.
- Benefits: Businesses must offer W-2 employees a range of benefits, including health insurance and retirement plans. 1099 contractors, though they have more flexibility, receive no such benefits from their employers.
Pros and Cons of 1099 for Employers and Employees
With any work-related contract, there are benefits and drawbacks for employers and employees alike. While independent contracts may provide a greater degree of latitude than the more rigidly defined W-2 roles, there are drawbacks to 1099 work as well. Let's explore the pros and cons below:
Pros for Employers
- Easier for New Businesses: One advantage to working with 1099 contractors is that new business owners can hire experienced professionals without binding them to long-term agreements.
- No Requirements to Offer Benefits: As we've mentioned, businesses are not required to provide various benefits to 1099 workers since they are not technically full-time employees.
- Short-Term Working Arrangements: 1099 workers offer an ideal solution for businesses that require flexibility in staffing.
Cons for Employers
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Pros for Employees
- Flexibility: 1099 contractors decide how and when they work, allowing freelance and contract employees the freedom to manage their own professional schedules and work-life balance.
- Higher Per-Hour Wage: 1099 contractors sometimes receive higher wages, as employers are not obliged to provide benefits that would otherwise be deducted from a contractor's paycheck.
- Tax Deductions: 10099 contractors can deduct expenses from their taxable income. These can include travel, work expenses, and more.
- Work for Multiple Employers: 1099 contractors decide when they work and who they work for.
Cons for Employees
- Higher Overall Tax Burden: While 1099 contractors can apply deductions to their yearly balance, their overall tax burden is generally much higher than those working under more traditional employment conditions. This disparity is partly due to the fact that 1099 workers must pay a 15.3% self-employment tax to cover Social Security and Medicare expenses.
- Higher Personal Administrative Load: 1099 contractors are not paid for time spent doing things like invoicing employers or filing taxes.
- No Benefits: As mentioned, 1099 contractors do not receive benefits like paid time off and health insurance. Considering that US families' average health insurance premiums exceed $23,000 annually, this can come at a significant cost to 1099 workers.
- No Guaranteed Work: Since 1099 workers are not full-time employees, steady work is never guaranteed.
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Pros and Cons of W-2 for Employers and Employees
Now that you understand the pros and cons of 1099 contracts let us unpack the advantages and disadvantages of W-2 contracts as they apply to both employers and employees:
Pros for Employers
- Attract Top-Tier Talent: As mentioned earlier, benefits play an enormous part in whether or not employees accept a job offer.
- Build Company Culture: By investing in a full-time workforce, a business also invests in staff training, team building, and other variables that contribute to a dynamic professional setting.
- Stable Workforce: In straightforward terms, W-2 employees are ideally suited for a business's consistent workflow. They are obligated to do their jobs in a particular manner.
Cons for Employers
- Higher Administrative Load: Employers are responsible for collecting income taxes and processing payroll for W-2 employees, which can lead to a higher administrative load for the company overall.
- Higher Tax Burden: Since employers are responsible for contributing payroll taxes for their W-2 employees, they may have to shoulder a heavier tax burden than they would if they were to hire 1099 contractors.
- Less Flexible: If a business has salaried employees on its payroll, adapting to seasonal or project-based work can be tricky, thus expanding the margin for inefficiency.
- Must Provide Extensive Benefits: Depending on the size and location of the business, employers must provide a range of benefit options to their W-2 employees. These benefits can include health insurance options, worker's compensation insurance, sick pay, and more.
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Pros for Employees
- Employment Benefits: Worker benefits form the backbone of our country's social safety net. Paying for employment benefits out of pocket can cost tens of thousands of dollars, which is far from realistic for many Americans.
- Legal Protections: W-2 employees are offered legal protection via practices like overtime pay and minimum wage, although the details of these protections vary from state to state.
- Limited Tax Responsibilities: W-2 employees don't have to pay a 15.3% self-employment tax. Their employer's payroll taxes are then applied to Social Security and Medicare.
- Stability: In addition to enjoying a clear role within their company, W-2 employees also reap the benefits of defined salaries or hourly wages.
Cons for Employees
- Fewer Tax Deduction Options: Unlike self-employed individuals, W-2 employees have limited options for deducting tax expenses.
- Limited Flexibility: W-2 employees usually have pre-defined hours and set vacation time. With a W-2 contract, employees have limited freedom to set their schedules.
- More Dependence on Employer: W-2 employees tend to rely on their jobs for the benefits they provide. However, they cannot choose from an unlimited variety of plans.
- More Employer Control: Employers can determine how W-2 employees conduct their jobs, meaning employees must adhere to specific professional requirements.
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1099 vs W-2 Employee Examples
The differences between 1099 workers and W-2 employees can be difficult to distinguish. Let's unpack some relevant examples for further clarity:
1099 Worker Examples
Below are two popular examples of 1099 workers:
- Freelance Writer: A freelance writer works on a per-project basis and is not attached to any formal employment agreement. For instance, if a publication accepts a pitch from a writer, they can hire said writer to research and write the story they pitched. Since the writer in question is a 1099 contractor, they will only be paid for this specific piece and not for any additional or ongoing work.
- Rideshare Driver: In most cases, a rideshare driver is a 1099 contractor, although some jurisdictions have made it mandatory for rideshare platforms to reclassify workers as employees. Since rideshare apps allow drivers to log in and work whenever their schedule permits, they are not technically classified as full-time employees.
W-2 Employee Examples
Let's explore two examples of W-2 employees:
- Full-Time Administrative Assistant: A full-time administrative assistant is a W-2 employee who is required to be in-office at specific, generally agreed-upon times (perhaps the most frequently cited example would be 9 AM to 5 PM, colloquially referred to as "9 to 5"). Employers dictate start times and other professional mandates.
- Schoolteacher: A schoolteacher is a W-2 employee who provides teaching services for specific hours on specific days throughout the calendar year. Schools dictate curriculum and other pertinent educational requirements, meaning teachers must adhere to the school calendar to ensure that their students are adequately prepared.
Payroll Taxes for W-2 vs 1099 Workers
Payroll taxes are one of the most important distinctions between W-2 employees and 1099 workers. W-2 employers must allocate deducted taxes towards Medicare and Social Security. 1099 contractors, on the other hand, are encouraged to save money throughout the year and apply it to their overall income tax balance.
1099 vs W-2 Form
Filing 1099 and W-2 forms with the Internal Revenue Service is a non-negotiable requirement. Failure to do so will result in financial repercussions. You can access the 1099 form here and the W-2 form here.
How to File 1099 vs W-2 Tax Forms
Below, we will explore the ins and outs of filing tax forms for both 1099 and W-2:
How to file 1099 forms
Suppose your business employs more than 250-plus 1099 contractors. In that case, it must file 1099 forms with the IRS via electronic filing (to be clear, businesses can also file electronically if they employ less than 250 1099 contractors). Employers must send a copy of the 1099 form to all contractors. Please reference the IRS website for the most up-to-date instructions on this process.
How to file W-2 forms
As with 1099s, businesses that employ more than 250 W-2 employees must file forms with the SSA electronically. Again, businesses that employ less than 250 individuals through W-2 can also exercise this option. These businesses must also file a W-3 form. Employers can provide employees with electronic copies of their W-2 with the employee's permission. All W-2 employees must receive a copy of their original work form.
What are the Legal Risks of Misclassifying 1099 vs W-2 Employees?
Failure to correctly classify your workers can lead to severe ramifications. This is the sort of thing that the IRS takes very seriously. If it is decided that you have intentionally misclassified workers, you could be subject to various financial repercussions, including 20% of wages paid, plus all FICA taxes.
The IRS reserves the right to seek criminal penalties of up to $1,000 for every misclassified worker within your business. If you believe you have accidentally misclassified a worker and wish to correct the issue, consider using the Voluntary Classification Settlement Program — it offers some relief from misclassification penalties.
W-2 vs 1099 Employees: Which Should you Hire for your Business?
Now that you're clear on what distinguishes a 1099 contractor from a W-2 employee, the time has come to decide which option best fits your professional needs.
If you're a new business, you may need more money or capacity to accommodate a full-time staff. If that's the case, 1099 contractors are a solid option. Maybe you're looking to get a short-term project off the ground. Again, contractors are an excellent fit for this sort of assignment. Many organizations use a calculated combination of full-time employees and contractors; there's no need to settle on using just one type of worker so long as said workers are classified accurately.
In deciding which type of worker to employ, businesses must partner with a payment processor capable of integrating with existing payroll services. By relying on a trustworthy and reliable merchant service provider equipped with third-party integration options, employers can organize payroll and staff management software under a single umbrella. This means your staff can access a multitude of features in a single location, including tracking for revenue and hours, payments to staff bank accounts, and much more.
FAQs for 1099 vs. W-2