To feel confident in your hiring process, payroll practices, and workforce management strategy, it’s essential to understand the difference between employees and independent contractors. As part of the employee classification process, you’ll also need to understand IRS requirements for completing 1099s and W-2s to pay taxes correctly and accurately.
Although you may not be required to pay taxes or withhold on payments made to independent contractors, with part- and full-time employees, you are obligated to withhold income taxes and pay FICA taxes, as well as unemployment tax on all wages paid to employees.
In this article, we’ll clarify the distinctions between employees and independent contractors, including when 1099s or W-2s are required. In the process, we’ll also discuss the benefits and downsides of hiring contract workers vs. full-time employees and how this can impact your business’ payroll, tax obligations, compliance considerations, as well as broader issues like productivity and workforce retention.
1099 Worker vs. W-2 Employee
An independent contractor or contract worker is technically self-employed and hired by your organization to complete a specialized task, or to fulfill a specialized role. Their self-employment status is further validated when they work for multiple businesses, set their own working hours, and/or use their own resources to complete contract work. Due to 1099 workers’ self-employed status, you are not obligated to withhold any taxes from payments made to independent workers. Instead, they acquire their own benefits and pay taxes on their own.
In contrast, an employee (full-time employee or otherwise), has been hired by your organization and is subject to an employment agreement. Organizations have greater control over an employee’s working hours and how they perform their work, but must also pay employment taxes on their behalf, withhold wage taxes, and possibly provide training and/or benefits, especially if local, state, or federal law requires it.
What Is a 1099?
If your business chooses to hire an independent contractor, you’ll need to use a 1099 form to report all payments made to the worker over the previous year. Most commonly, businesses must use a 1099-MISC (Copy B) to report payments. This form is strictly required if your business paid $600 or more to an independent contractor over the course of a calendar year, and must be sent to the contractor by January 31st of the subsequent year.
In addition to providing a 1099-MISC to the independent contractor, your business must also file a 1099-MISC (Copy A) with the IRS by January 31st of the year following a worker’s completed work. After completing all of your 1099s for a given tax year, you will also need to complete Form 1096, which summarizes all 1099 preparations, and submit it to the IRS by January 31st. However, if you opt to file all of your 1099s electronically, Form 1096 is not required.
What is a W-2?
If your business chooses to hire an employee, you’ll need to use a W-2 tax form, which allows businesses to report yearly compensation paid to an employee and catalogs all payroll taxes that were withheld from wages. Any employee who receives a W-2 has been paid through their employer’s payroll system with all payroll taxes automatically withheld over the course of the work year. These withholdings include FICA taxes (Social Security and Medicare), but employers must also pay federal and state unemployment taxes and other applicable taxes.
As an employer, you are required to mail a W-2 form to any qualifying employee by January 31st of the year following completed work.
Determining Who is an Independent Contractor
Although distinguishing between an independent contractor and employee might seem intuitive, determining classification can sometimes be quite difficult. Using the IRS’ categorical definitions to guide your classification process can help you clarify status on a case-by-case basis.
Generally speaking, the IRS asks you to consider the degrees of behavioral, financial, and relational control your organization exerts over the worker. For instance, if your company consistently controls how a worker does their job and on what timeline, reimburses expenses or supplies, or offers employee-like benefits, the worker may (using IRS guidelines) be an employee, even if they are currently classified as an independent contractor. This is especially true if the contractor is performing a vital business function or if the relationship is more or less permanent.
However, if the business exerts limited or minimal control over the worker’s schedule, does not offer reimbursements, and does not generally offer any benefits that are typically extended to full-time employees, the worker is fairly regarded and classified as an independent contractor.
The IRS only offers general guidelines for these determinations. Regardless of which classification you use for a worker, ensure that you document all of the factors that contributed to your final determination/classification, whether they are classified as an employee or an independent contractor.
Benefits and Disadvantages of 1099 Employees
Independent contractors or 1099 employees can often offer expertise that is not present internally within a business or can supplement existing skill sets. In a best-case scenario, they are able to provide high-quality, specialized work as needed and without regular management or intervention on the part of the employer.
Since independent contractors are technically self-employed, there’s also no need to withhold payroll taxes, or offer benefits or training. In most cases, this leads to cost savings for your business.
In terms of downsides, most employers have less day-to-day control over an independent contractor’s workflow, scheduling, and work methods. Because contracts or working agreements can sometimes be short-term or situational, there’s always the possibility of receiving less conscientious work than what you would receive from an employee. It’s also possible for breaches of contracts or verbal agreements that established working expectations to be violated. For this reason, it’s wise to have any important contracts with independent contractors reviewed by a legal professional. Depending on your business’ industry or the type of work that’s being completed, you may also need to have a conversation with the contractor regarding protection against work-related injury, whether that involves general liability insurance or another option outside of traditional workers’ compensation.
If you determine that your business would benefit from increasing its volume of independent contractors, remember that you are still entitled to offer these workers a small business benefits package, including health insurance, retirement plans, or other perks. It’s important to speak with your HR or HCM consultant to determine whether this is a useful strategy for your business to improve recruitment, hiring, and employee retention.
Benefits and Disadvantages of W-2 Employees
W-2 employees often have a more obvious and pronounced investment in the success of the company they work for and rely on the benefits, financial security, and consistency that employee status provides. Although contractors can often assist with specialized tasks, employees can be relied upon to adapt to the shifting needs of the company, including during challenging periods when the entire team must work late or temporarily adopt new or shifting responsibilities.
Generally speaking, employers have significantly more say in employees’ work schedules, work methods, project timelines, and the use of company time and resources than with an independent contractor. Employees can foster improved consistency, dependability, and project outcomes in-house, contributing to higher productivity and client satisfaction.
In terms of disadvantages, employers must pay FICA taxes on top of any employee’s wages, in addition to providing training, benefits, and perks ranging from health insurance to PTO and wellness programs. Employees usually require more physical resources, as well, whether it’s supplies, reimbursed expenses, physical spaces to work at a company site, and more. Lastly, whereas independent contractors generally require minimal daily management, employees require clear scheduling, more complex payroll integration, benefits administration, training and a more involved managerial approach.
Simplify Payroll and HCM
Employee misclassification can lead to sizable financial penalties or even lawsuits from current or former workers. Employers should carefully consider how they can improve their payroll practices and workforce configuration to make the most of employees and independent contractors to improve productivity, increase employee retention, and attract top talent for their business.
We offer a comprehensive payroll solution that provides real-time payroll processing, employee self-service, multiple pay options, and fast reporting and analytics. Most importantly, each client has access to a dedicated payroll expert who can help them navigate employee classification and organize payroll and taxes for W-2 employees vs. independent contractors.
Ready to make payroll intuitive, employee-friendly, and hassle-free? Contact us today to start the process.