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W-2 vs. 1099: Know the Difference Between W-2 Workers and 1099 Contractors

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December 29, 2020
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With positions and scopes of work growing increasingly complex, more and more companies opt to hire different types of workers. Deciding whether to hire full-time employees or independent contractors depends on several factors, including taxes, compensation, and benefits. This article will outline all of the relevant factors so you can understand them better and make an informed hiring decision.

A summary: 1099 contractors vs. W2 employees

We deal with two types of workers in this article: the independent contractor (1099 worker) and the employee (W2 worker).
Simply put, the W2 worker is your standard employee - you pay them a salary or wage, withhold their income tax, pay their payroll taxes, insurance, and provide benefits. On the other hand, you have an independent contractor who works for your company on a per-project basis for a set fee. They are not entitled to any taxes and benefits - being self-employed, they cover all of those expenses for themselves.
There are benefits and challenges for each of the two worker types, and different legal obligations and tax forms. Continue reading for a more detailed breakdown.

What is a 1099 worker?

A 1099 worker is often known as an independent contractor or a freelancer. These are essentially self-employed workers, and you are their client. The name 1099 worker is derived from the 1099 tax forms used for reporting their income. In most industries, independent contractors are usually hired for specific projects and limited, short time. However, in the modern (and global) work environments, contractors are often hired for more extended periods for all those services that are not the core of your business.

The most important aspect of hiring independent contractors is taxes - contractors pay their own taxes, as well as other benefits. You are essentially paying them a lump sum for their services, while the business expenses such as equipment and licenses fall under their responsibility.

Contractors are basically small business owners who work for multiple clients and don't enjoy employee-type benefits.

Pros of hiring 1099 workers

Many companies can benefit significantly from hiring 1099 workers, especially in addition to their existing base of full-time workers. We've written extensively about the benefits of hiring independent contractors, but here are the most important ones:

Supplementing your business needs

If your company needs certain services (such as design projects, programming, or machine maintenance), 1099 workers can provide you with great quality of work without the need to hire a dedicated full-time position

Managing a fluctuating workload

Since contractors are usually hired per project, there is no need to worry about them not having anything to do once their tasks are over. 1099 workers are ideal for companies whose work has seasonal upticks or any other fluctuations during the year.

Gaining access to a broader talent pool

When you hire independent contractors, you can choose from a global talent pool. Maybe the specialist you are looking for is located halfway across the world and offers incredible quality for a lower price. Unlike with employees, you can hire contractors anywhere in the world without any legal barriers.

Saving money

Full-time employees sign employment contracts that protect their rights and put specific responsibilities on their employers. On the other hand, contractors are not employees, and they bear the risks and benefits of their businesses themselves, which leaves their clients with a significant portion of savings on taxes and benefits.

Cons of hiring 1099 workers

Now that we laid out the pros let's see what the cons of hiring independent contractors are:

The lack of control

One of the defining aspects of contractors is their independence while performing work. As their client, you can not control when or how long they work, their workspace and location, and their methods. The degree of control you have when working with 1099 workers is the end result of their work, and whether it satisfies the criteria you agreed on. The bottom line is that 1099 workers are not an excellent choice for those with trust issues or micromanaging needs.

Ownership challenges

A significant factor to pay attention to when forming contractor relationships is the ownership of the work and its final products. In some cases, if you haven't explicitly stated otherwise, the work results could belong to the contractor and not the hiring company. Make sure to include an ownership clause or copyright transfer clause into the contract you make with the 1099 worker.

Misclassification risks

By far, the biggest issue with hiring contractors is the misclassification risks that come along with this form of a working relationship. In the US, the IRS pays close attention to employee misclassification and treats it as a severe offense. Read more about what misclassification is and how to prevent it.

What is a W2 employee?

A W2 employee, usually known as a full-time employee, is a person hired by your company under a standard employment contract. This contract usually offers a salary, paid benefits, tax withholding, and other perks and benefits. The name W2 worker also comes from a tax form, the Form W-2, used to report employees' income.
Unlike contractors, employees need to abide by company rules (such as code of conduct) and follow work hours, holiday schedules, tasks, and requirements for their respective positions.

Pros of hiring W2 employees

Even though most companies and recruiters are familiar with employment contracts and procedures, here are some benefits of hiring W2 employees:

Control and oversight

W2 employees work under the guidance and oversight of their employers, which means they work at the employer's premises, follow procedures and protocols, and adhere to the company's work hours. In other words, the hiring company can control every aspect of how employees do their job, including methods and outcomes.

Ownership clarity

All the work employees do for a company automatically belongs to the company, and there are no uncertainties, unlike when it comes to 1099 workers.

Exclusivity

Employees, especially those who have full-time contracts, usually work exclusively for their employers. This exclusivity means they don't take other jobs and clients, focusing entirely on their full-time job.

Cons of hiring W2 employees

Similarly to 1099 workers, W2 employees come with their own set of challenges during hiring and employment:

Costs for the employer

If you are an employer, your W2 workers are entitled to tax withholding, health insurance, and other employment benefits. Depending on your location, these expenses can quickly add up and increase your business expenses. Don't forget the legal and bureaucratic aspects of these contracts, and they can add up quickly too!

Predicting the workload

Once you hire an employee, you can't simply fire them because their workload has gotten smaller. Hiring employees means predicting their positions, roles, and workloads well and making sure they always have tasks to complete, which isn't always easy.

Training and equipment

W2 employees work for your company exclusively, which means they use your equipment, as well as your work methods and strategies. Once you hire a new employee, you need to onboard them and provide training and equipment to get them started. Both of these require time and money, once again increasing the cost for the employer.

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How to determine if a worker receives Form W-2 or Form 1099?

Believe it or not, there isn't a strict, determined formula to indicate whether a company should use Form W-2 or Form 1099-NEC (previously Form 1099-MISC). The IRS, however, offers guidance on some factors that help determine whether a worker is a contractor or an employee. These factors are:

1. Behavioral - Does the company control how the worker does their job and what they do to achieve the work results?

2. Financial - Does the company reimburse expenses to the worker? Does the company influence the overall financial stability of the worker's business? Does the company provide tools and equipment for the worker?

3. Type of relationship - Does the worker get benefits such as days off, pension, and insurance? Is the job a worker does for the payer a key aspect of the business? Is the relationship long term, or does it end once the job is done?

If the relationship between the worker and the company resembles a long-term, stable employment relationship, the IRS can determine the worker is not, in fact, an independent contractor.

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

Actually, yes, this is possible! The IRS gives an example on their website of a single person being both an employee and an independent contractor with different written contracts. However, an IRS audit may happen if your company files both tax forms for the same person. The IRS may want to check whether you are doing everything according to the law and not misclassifying employees.

Tax differences between W-2 employees and 1099 contractors

Let's cover some fundamental tax differences between employees and contractors. Deciding to hire one or the other type of worker determines how your company and the worker will be taxed. The key differences are:

The tax forms

Employers need to file the W-2 form (Wage and Tax Statement) for full-time employees, while for contractors, the company files Form 1099-NEC, which is the form used to report contractor income on their tax return.

Social security and employment taxes

Contractors pay their own social security tax and benefits (including health insurance), while for employees, companies pay Medicare taxes and social security.

Income tax

Independent contractors are not entitled to income tax payments from their clients, while W2 workers have their income tax withheld by their employer. 1099 contractors also pay their own self-employment tax.

Unemployment insurance and unemployment tax

Only W2 employees are covered by the unemployment tax payments by the employer. Independent contractors need to pay for these benefits themselves.

Worker's compensation

Since payroll taxes do not cover them, contractors don't benefit from worker's compensation insurance. However, this also means that if they suffer from injuries while working for your company, they could sue you for compensation.

Paid time off, sick leave, parental leave, and other benefits

Companies only provide perks and benefits to their employees. Since independent contractors are running their own small businesses, they schedule their own days off and the degree of benefits they want to have.

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