Simply put, a W2 employee is someone who works directly for your company and is consequently hired in conjunction with an employee agreement. On the flip side, a 1099 worker is an independent contractor that you might sub work for a specific project out to. They don't work directly for your company and would thus bill you by the contract that was generated between you. There are several key differences between W2 and 1099—not the least of which is the tax ramifications of having an employee versus hiring work out to a contractor. In this article, we take a look at a few of those differences as well as the benefits and drawbacks of W2 and 1099.
The Basics When it Comes to Independent Contractors vs. Employees
Independent contractors are just that. This is a person who you will hire independently of your actual company to complete a task or to work on a project for you. They will not be under your direct supervision beyond addressing the specific needs of the task at hand. To this end, they will complete the job and consequently, set their hours, utilizing their tools and resources. Most 1099 contractors will usually be involved with multiple projects and multiple companies at any given time. As far as payment, this will be determined beforehand and you will pay them the entire amount without any tax holdbacks as an independent contractor pays their taxes.
An employee, on the other hand, is someone who works directly for your business. Upon hiring that employee, you will present them with an employee agreement—this represents the terms and conditions of their employment. Because they are directly associated with the company, you will withhold taxes from their wages; you will also likely be required to provide certain benefits. As they are under your supervision, you will set their hours, decide what they work on, where they work, and how they complete that work.
Understanding 1099 and W2 forms
Both a 1099 and a W2 are types of tax forms. With a 1099-MISC, for instance, a company owner will fill out the form and ultimately this will record any payments made to a contractor. The contractor of course will pay their income taxes versus having anything withheld. A W2 is used for employees—an employer will withhold payroll taxes from a direct employee's wages.
Key Differences Between the Two
As noted, one of the primary differences between the two will be the amount of direct control an employer has over that individual. With a 1099 worker, they will set their schedule, work for multiple employers, and utilize their tools to accomplish the job. As far as tax purposes go where the IRS is concerned, they examine several key factors in determining whether or not a person is truly an independent contractor.
- Behavior: Does the employer control how that person does their job?
- Financial: How is the contractor paid? Who provides supplies? Are expenses reimbursed?
- Contractual: Is there a contract in place? Does the worker in question receive benefits? Is the position a permanent one?
When it comes to the IRS, they look at the entire overall picture to decide whether or not someone is an independent contractor or a direct employee. If you misclassify an independent contractor, this could present some major issues down the road. Thus, you want to ensure that the correct forms are used and the relationship is clearly outlined. Otherwise, financial penalties could apply.
Why such a big deal regarding worker status—an independent contractor versus an employee? Largely, this is because if someone is an independent contractor, the employer is not responsible for paying unemployment on that person and/or any other relevant taxes as well as insurances. Employees need to be covered by worker's comp and unemployment insurance. If in fact, the IRS finds that you misclassified an independent contractor, you will most likely have to repay any taxes and benefits missed. You might also have to pay back taxes as well as Social Security and Medicare. The fines can also add up significantly.
Benefits of Independent Contractors
In recent years, companies have been opting to contract out more and more of their workload to 1099 workers. This is because independent contractors can be quite a bit more affordable than using full-time employees. Not to mention, they are often uniquely skilled in a certain area of specialization such that you might not be able to find an employee. And of course, you're not having to pay taxes and insurances on them as they provide and/or pay their own.
Once You Hire a Contractor or Employee…
Deciding whether to go with an actual employee or an independent contractor is a decision that many business owners will need to take some time with. That said, upon hiring either type of worker, you need to make sure that you have the right paperwork and documentation filled out and filed. For an employee of the company, this will be a W2 form; for an independent contractor, you will use 1099. This is one of the main differences between W2 and 1099.
Essentially, a W2 is a form that the business uses to report the amount of money paid to an employee over a year. That employee will be paid via payroll and consequently have payroll taxes withheld from the earnings. All employers have to get their W2s out by January 31st to enable the employee to have ample time to prepare their tax returns.
On the other hand, a 1099 form is used to record payments made to an independent contractor throughout a year. If the business has paid a contractor more than $600 during a calendar year, they must then send that contractor a 1099-MISC by January 31st.
Again, it is so important to keep track of employeescontractors' hours, any payments made, and then of course fill out the requisite forms when the time comes.