W-2 employee vs. 1099 workers
W-2 employees receive a regular paycheck and a W-2 statement at year-end, showing their income earned and taxes withheld. On the other hand, 1099 workers are self-employed independent contractors. They're typically paid under the terms of a contract and receive a 1099 form at year end.
In prior years, payments to 1099 workers were reported in Box 7 of Form 1099-MISC. However, beginning in 2020, these payments should now be reported on a new form.1 This new form is called the 1099-NEC, for nonemployee compensation.2
There are several significant legal differences between employees and contractors.
- Taxes. Employers are responsible for withholding income taxes, Social Security, and Medicare taxes from employee wages and for paying the employer portion of the social security tax on the employee's income. Contractors are responsible for paying those taxes out of their own income.
- Employment laws. Employees are covered by several federal and state employment laws, including minimum wage and overtime. Contractors don't receive the same protections.
- Benefits. Employers may be required to provide paid vacation, holiday, sick pay, and health insurance for full-time employees. Contractors don't receive the same benefits.
- Insurance. Employers are responsible for purchasing workers' compensation insurance and paying unemployment insurance taxes for employees. Contractors aren't covered by workers compensation or unemployment benefits.
How to classify a worker
When you make your first hire, choosing between an employee or independent contractor isn't as simple as picking one or the other. The IRS has rules about who can be treated as an independent contractor and penalizes employers who treat employees as contractors simply to avoid taxes.3
Those rules fall into three broad categories.
- Behavioral control. A business has the right to direct and control work performed by an employee. This includes instructing the worker on when and where to work, what tools to use, and where to purchase supplies. An employer generally has no say in how an independent contractor works only the results of that work.
- Financial control. A business has a right to control or direct financial aspects of an employee's work. For instance, a business owner may purchase the equipment an employee uses in their work and reimburse expenses. The employer also has a right to mandate that an employee cannot have a second job or a competing side business. Independent contractors typically purchase their own equipment, cover their own expenses, and are free to work for other clients or seek out other business opportunities.
- Relationship. The IRS will consider how the worker and business perceive their relationship. A written contract between the company and the worker that states the worker is an independent contractor is a good indication that the worker is an independent contractor. However, it also considers other aspects of the relationship, such as whether the tasks performed by the worker are key aspects of the business.
So what happens if you get it wrong?
If the IRS determines that a business classified an employee as an independent contractor without a reasonable basis for doing so, the company could be liable for:
- Unpaid wages, including overtime
- Workers' compensation benefits
- Retirement contributions
- Employee benefits
- Back employment taxes
- Health insurance premiums
- Penalties and interest on unpaid state and federal taxes
In extreme cases, your business could even face criminal penalties or a lawsuit from the worker.
When it comes to classifying workers, don't take any chances. Figure out how the workers you hire should be classified from the start and make sure their role stays within the definitions provided by the IRS. It may take a bit of thought and research to figure out whether a W-2 employee or independent contractor is right for your business. Your lawyer or tax professional can help ensure you don't run afoul of IRS requirements.