What's the difference between a Form W-2 and a Form 1099-MISC or Form 1099-NEC?
Sorting the differences for your business
Running any business can be difficult. There are lots of things you have to stay on top of – from inventory to scheduling to bookkeeping. As a business, you’re responsible for filling out tax forms at the end of the year and sending the correct forms to those who have worked for you. When it comes to reporting payments to employees and contractors, there are a few important forms you should know about: Form W-2, Form 1099-MISC, and Form 1099-NEC. So, in this article, we’ll take a look at each of these forms in greater detail, starting with Form W-2.
What is Form W-2?
Every year, employers are required to send tax forms to their employees. The main form that an employer uses is Form W-2 (which is where the term W2 employee comes from). This form is also known as a Wage and Tax Statement. It’s a required form that any employer who pays for services from an employee must send. As an employer, you’ll send one copy of Form W-2 to each employee, and another copy of each employee’s Form W-2 to the Internal Revenue Service (IRS), Social Security Administration (SSA), and state and local tax authorities, if applicable.
But what does Form W-2 report? There are a few key pieces of information that get reported on Form W-2, including:
- The employee’s wages, tips, and other compensation
- The employee’s income and social security taxes withheld
- Wage and withholding information to the employee and the Social Security Administration. The Social Security Administration shares this information with the IRS
As an employer, you should begin to verify your employees’ information in October or November of the tax year so that you’re ready for year-end tax form processing and distribution. You’ll need to verify your employees’ social security numbers, legal names, and current mailing addresses. Once you confirm this information, you’ll prepare W-2s to distribute in January.
Any employee who receives at least $600 from an employer must file a Form W-2. It doesn’t matter if the employee was full-time or part-time. That could mean that employees who worked more than one job would need to file all Form W-2s they receive for the calendar year. Now that you know more about Form W-2, let’s look at Form 1099-NEC and Form 1099-MISC.
What is Form 1099-NEC?
Prior to 2020, if your business hired freelancers or contractors, you would send them a Form 1099-MISC to report their income. However, starting in 2020, the IRS re-introduced Form 1099-NEC to help businesses report any non-employee compensation. Currently, non-employee compensation includes payments to individuals not on your payroll, but rather on a contract basis to complete a project or assignment.
If your business works with independent contractors, gig workers, or other self-employed individuals, you’ll need to file Form 1099-NEC for each person whom you paid more than $600 during the tax year. However, if the independent contractor is registered as a C corporation or S corporation, a 1099-NEC is not required. You can check the contractor’s Form W-9 for this information. If you send Form 1099-NEC to a contractor, you’ll also need to send the IRS a copy.
As you would for employee Form W-2s, you’ll want to confirm the freelancer and contractor information in October or November. You’ll also need to verify each freelancer’s social security number, legal name, and current mailing address.
If you issue a 1099-NEC form to a contractor, they are responsible for payroll taxes and self-employment taxes. Unlike a W2 employee, you don’t pay payroll taxes; the contractors are responsible for those themselves.
What is Form 1099-MISC?
Again, prior to 2020, businesses reported all contractor and freelancer information on Form 1099-MISC. So, while that reporting shifted to Form 1099-NEC, there are still times when your business may need to issue a Form 1099-MISC. You’ll need to issue a Form 1099-MISC if you made any of the following payments:
At least $10 in royalties or broker payments in lieu of dividends or tax-exempt interest.
At least $600 in:
- Prizes and awards
- Other income payments
- Medical and health care payments
- Crop insurance proceeds
- Cash payments for fish (or other aquatic life) you purchased from anyone engaged in the trade or business of catching fish
- Generally, the cash paid from a notional principal contract to an individual, partnership, or estate
- Payments to an attorney
- Any fishing boat proceeds
Now that you know about each of these forms, let’s define the difference between employees and contractors.
Independent contractors vs W2 employees
It’s important for small businesses like yours to ensure proper worker classification because employee misclassification can be costly. There are three main proofs of evidence the IRS uses to determine if someone is a W2 worker or contractor: behavioral control, financial control, and type of evidence. Let’s take a closer look at each of these factors that can indicate an employer's degree of control over an employee. To start, behavioral control is made up of the following proofs:
Type of instructions given
If the worker receives extensive instructions on how the work is to be completed, that person may be an employee. Instructions can include:
- When and where to do the work
- What tools or equipment to use
- What workers to hire or to assist with the work
- Where to purchase supplies and services
- What work must be performed by a specified individual
- What order or sequence to follow when performing the work
Degree of instruction
The more detailed the instructions, the greater control a business exercises over the worker. The more instructions, the more likely a worker is an employee.
If you have an evaluation system to measure the details of how the work gets done, that usually indicates an employer-employee relationship. If the evaluation only measures results, that could be either an employer-employee relationship or a contractor.
Extensive training about required procedures and methods usually indicates that an organization wants the work done in a certain way. These trainings, along with a robust onboarding process when hiring employees, can suggest that a worker is a full-time employee. Another tell-tale sign of an employee is that there is frequent or ongoing training on the required procedures and methods.
Another aspect of control is the financial control that exists between the two parties. According to the IRS, there are a few factors that help define the financial control:
If a worker has a significant investment in the equipment they use while working for someone else, that may signify that the person is a contractor. However, some occupations require significant investment from employees. There are no specific dollar amounts required for significant investment, and a significant investment is not necessary for independent contractor status.
Independent contractors are more likely to have unreimbursed business expenses than are employees. Fixed ongoing costs that are incurred regardless of whether work is being performed are especially important. However, employees may also incur unreimbursed expenses in connection with the services that they perform for their business.
Opportunity for profit or loss
The opportunity to make a profit or incur a loss is another important factor. If a worker has a significant investment in the tools and equipment used and if the worker has unreimbursed expenses, the worker has a greater opportunity to lose money. Having this possibility of incurring loss indicates the worker is an independent contractor.
Services available to the market
An independent contractor is generally free to seek out business opportunities, whereas an employee might not be allowed to advertise or work in the market.
Method of payment
Guaranteed regular wages is usually a sign that the worker is an employee. In contrast, independent contractors’ income usually fluctuates over the year, and they usually get paid a flat fee; although some professions pay contractors hourly.
The third criteria the IRS uses is the type of relationship. Type of relationship refers to facts that show how the worker and business perceive their relationship to each other. This includes:
Although a contract may state that the worker is an employee or an independent contractor, this is not sufficient to determine the worker’s status. It’s more important to determine how the parties work together.
Employee-type benefits include items like health insurance, pension plans, paid vacation, sick days, retirement plans, workers’ compensation, and disability insurance. This is usually a sign that there is an employer-employee relationship. But it should be noted that a lack of benefits doesn’t automatically mean that a worker is an independent contractor.
Permanency of the Relationship
If you hire a worker with the expectation that the relationship will continue indefinitely rather than for a specific project or period of time, this is generally considered evidence that the intent was to create an employer-employee relationship.
Services Provided as Key Activity of the Business
If a worker provides services that are a key aspect of the business, it is more likely that the business will have the right to direct and control the person’s activities, which likely makes them an employee.
If you’re still unable to determine whether a worker is an employee or a contractor after weighing each category of evidence, you’ll need to file a Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, with the IRS.
What else should you know about W2s and 1099s?
When it comes to contractors, another important difference is that the Fair Labor Standards Act (FLSA) protections don't apply to contractors. The FLSA is a federal labor law that mandates minimum wage and overtime pay. Because contractors work independently of the business, they pay their own taxes as a separate entity. Therefore, as a business owner, you’re not responsible for any of the employment tax payments that you’d usually withhold from employees’ paychecks. These taxes include federal, local, state, and unemployment taxes, in addition to FICA taxes, which include social security and medicare taxes.
While you may think it’s a simple mistake, employee misclassification on tax forms can come with significant penalties. If you misclassify someone as an independent contractor instead of a W2 employee, you can be subjected to penalties for not paying the appropriate employee taxes. You could also be subject to penalties for using the wrong form. If you misclassify a W2 employee, you might also be subject to penalties for not taking appropriate state withholdings and deductions, and levies for not making other required state contributions.
The IRS penalty per statement for failure to file, or for failure to furnish accurate Forms W-2 and 1099 (including accurate names and social security numbers) is $280 per statement, with an annual cap of over $3.3 million. Another potential issue is that an employer could be liable for unpaid overtime for any misclassified workers.
The bottom line is that Form W-2, Form 1099-NEC, and Form 1099-MISC each have a specific use. As a business owner, it’s vitally important to know the difference and use each form correctly. After reading this article, you should have a better understanding of each form and what you should use each form for. As you’ve read this article, you should be aware that making mistakes on these forms can be costly for your business.
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