1099 vs W2 and what you should know for your business
With a seemingly infinite number of jobs, the variety in types of employment is staggering. This can be especially true for businesses that frequently offer temporary positions, like seasonal work, project based employment, “gig workers”, and contracting.
Positions such as these may require different tax forms than standard employees, specifically, a 1099 form being sent out to them detailing their compensation rather than the typical W-2. These forms provide employees the necessary information they’ll need to file their taxes, and you’ll also need to send a copy to the Internal Revenue Services (IRS), Social Security Administration (SSA), and any applicable state or city authorities.
Knowing which form a position requires depends on multiple factors and isn’t always as clear cut as it seems. This article will focus on breaking down W-2 and 1099 tax forms, when they should be used and how they’ll affect things on your end.
The difference between 1099 and W-2 forms
A W-2 is the most common tax form sent out to employees and it details their total compensation throughout the year, along with the various tax withholdings that took place. Employees are given multiple copies, one of which they’ll send to the IRS when they file their taxes.
Employers are required to provide W-2’s once an employee surpasses $600 in compensation, regardless of full-time or part-time status. Typically, businesses use the closing months of the year to double check that they have the employee’s correct social security number (SIN), mailing address, and filing status, in which case they’ll send out the forms in January of the following year.
The individuals who receive W-2s are commonly referred to as “W-2 employees”; more on this soon.
1099 tax forms are recently growing in popularity, with more businesses taking advantage of contracted work, also referred to as “1099 workers”. 1099s are split into two types, the NEC and the MISC.
The 1099 non-employee compensation form (Form 1099-NEC) is the standard tax form that contracted workers who earned more than $600 will need from you at the end of the year. This form acts similarly to W-2s, but with the striking difference of not including tax withholding as that obligation to be fulfilled by the worker.
The 1099 miscellaneous income/information form (Form 1099-MISC) saw more use prior to 2020, but has recently been overshadowed by the NEC form. However, it’s not without use, and still sees circulation when contracted workers are compensated in forms of payment that aren’t subjected to self-employment-taxes, such as:
- Medical payments
- Attorney fees
- Crop insurance
- Substitute dividends and tax exempt interest payments
How to determine if a worker receives a W-2 or 1099
We’ve explained each form, but how can you make sure that the individuals you compensate receive the right form? Not only are there penalties if you misclassify a worker, but there’s also the potential for lawsuits, losing employees and damaging your reputation as a business owner.
To put it simply, 1099 workers are individuals who work alongside your business, and W-2 employees are individuals who work on behalf or representative of your business. Another way to look at it is that 1099 workers typically specialize in a certain craft, and businesses “rent” out their services for a project or specific timeframe, while W-2 employees are hired and trained to perform various jobs and duties and may work multiple positions throughout their tenure.
Even though both employee types can offer crucial work on behalf of the business, W-2 employees are more closely established into an employer’s jurisdiction, and therefore, are legally required to be offered services like tax withholding, health care benefits and retirement programs.
Just as the 1099 form suggests, 1099 workers are independent contractors (also known as freelance workers) who are most likely temporary and may even be offering their services to multiple other businesses. They’re typically brought on to complete a specific project, or offer their services as needed throughout a defined or indeterminate timeframe. Often there is a written contract involved to clearly define services, expectations and compensation. They’ll make their own hours, and have more freedom than typical W-2 employees (so long as the job gets done and employers choose to keep them on).
An important distinction with 1099 workers is that they assume all business expenses when they’re brought on to a job. Whatever costs come their way in pursuit of fulfilling a service will be their own responsibility, unless the employer chooses and agrees to compensate them. This includes workers’ compensation, health insurance and other employee-type benefits. In this way, they can be seen as their own “small business”.
For example, if a contractor is signed on to create websites for a small business, they won’t be able to charge the employer, internet fees, program subscriptions, or purchasing a high end computer to fulfill the job. Those expenses will be the 1099 worker’s to cover.
As the W-2 form suggests, W-2 employees are employees which businesses have taken a long-term commitment in, who often work solely for them, and are provided benefits, incentives, and structure by their employers. They’ll be more supervised, and are trained to perform multiple jobs and duties. They’ll be on a company’s payroll and have access to HR, as well as laws in place to protect them.
An additional difference between the two is that W-2 workers are not subject to assume costs related to their services. If an employee is hired to serve ice cream on a bike cart, they’re not charged by the company for flat tires, purchasing silverware, permit fees, or any other costs related to the job.
Making the call
Because the required form is based on the strength of the relationship between an employer and an employee, making the call can sometimes be difficult. However, the IRS has provided some general guidelines to help determine which workers should receive which form:
- Behavioral: How much can the employer control what, when, how, and where the worker accomplishes tasks relating to their job?
- Financial: Who’s making the decisions as to how much and in what forms of payment the worker is being paid? Is the worker adapting to the employer’s payment plan, or the other way around?
- Type of relationship: What additional benefits, such as workers’ compensation and health insurance, are being offered to the worker? Is the contract or employee agreement open-ended or closed? What level of commitment is there between the two parties?
If you’re unsure of which form to provide for a worker, file a SS-8 with the IRS and they’ll make a determination for you. But odds are, the more independent the worker is, the more likely they should receive a 1099. If the worker is given additional benefits and answers more often to the employer for various daily tasks, they should be given a W-2.
For the employer, this is one of the biggest differences between the two employment types and why many businesses are beginning to enlist more contractual help. Unlike W-2 employees, employers are not responsible for withholding payroll taxes from 1099 worker’s payments. This saves your payroll significant time and allows you to focus on other business decisions or focus on other tax responsibilities.
By law, employers are required to perform accurate tax withholdings from their employee’s paychecks corresponding to their tax information provided in their W-4s (see our article: "How does payroll withholding help a company's employees?")
Calculating hourly rates
1099 workers might choose to be paid hourly or per completed project/service. Because you won’t be supplying them with additional benefits, they’ll often ask for a wage that’s higher than your W-2 employees.
Furthermore, 1099 workers will not only be paying their own income taxes, but often more so than W-2 employees. Typically, an employer and employee cut employment taxes down the middle, with both parties paying 7.65% of an employee’s gross income. 1099 workers, however, will have to pay the entire 15.3% as a “self-employment tax”.
Expect 1099 employers to have more terms and conditions on their end as compared to W-2 employees, but keep in mind the extra responsibilities on their end and why they’re justified in asking for greater wages.
Both the W-2 and 1099 form need to be filed by Jan 31st the year following the year being filed for. As mentioned earlier, it’s good practice to spend a year’s closing months verifying staff’s social security numbers, tax information and mailing addresses.
Consequences due to misclassification
In the event you misclassify a W-2 employee as a 1099 contractor, you’ll be held liable to pay back all the benefits they missed out on for however long they were wrongly classified. Furthermore, you’ll be required to pay any employment taxes due to both them and the IRS. It’s in every business owner’s best interest to comply with these penalties as the employee has good legal grounds to sue.
Contract work is growing increasingly popular, and business owners have a lot to benefit from leasing their services. But, there are many things W-2 employees offer that can make them more valuable to your business than 1099 workers in the long run.
As with anything, the exact needs and aspirations of your business will best determine which employment type you should make use of, and many companies implement both types. Regardless, every business owner needs to be informed of the differences between them so they can send out correct tax forms, avoid penalties and correctly manage their staff.
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