To make the best staffing decisions, it's essential to understand the differences between salaried and contract employees. After all, salaried and contract employees have different responsibilities, payment structures, and expectations. As such, knowing these distinctions is crucial for ensuring your business's efficient and effective functioning.
So, in this article, we'll discuss the differences between W2 employees and 1099 contract employees and explore how to hire these employee types to your advantage.
There's lots to discuss, so grab a cup of coffee, and let's get into it!
Why's It Important to Know the Difference Between a W2 Employee and a 1099 Contractor?
US tax law splits workers into specific categories. These categories determine the amount and the type of taxes that must be paid to the IRS.
To help you better understand these different worker types, we’ve listed the employee categories we’ve just alluded to (as defined by the IRS):
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Independent contractors: Those who are self-employed. I.e., they don’t have a relationship with a client that could be considered employee-employer.
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Employees (common-law employees): Those performing services defined by someone other than themselves, i.e., what they do, when they do it, and who they do it for.
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Statutory employees: This status refers to independent contractors who are considered employees for the purposes of withholding tax.
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Statutory nonemployees: This applies to persons employed by a business whose remuneration isn’t based on hours worked. For instance, it might be that their wage is based on direct sales or some other output. Statutory nonemployees aren’t considered employees for tax purposes.
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Government workers: Those who serve as officers, employees, or elected government officials.
Knowing these categories' differences is essential because the government holds businesses liable for misclassifying employees. According to Internal Revenue Code 3509, if you incorrectly categorize a worker, you'll have to compensate the IRS for federal payroll and insurance contribution taxes that would have otherwise been deducted from an employee’s salary.
For instance, an employee’s tax contribution is supposed to be 7.65% (6.2% for social security and 1.45% for medicare tax) of their wage. In this instance, an employer would withhold this amount from the employee and give it directly to the IRS when they fill out their employee’s taxes.
However, suppose you fail to classify your worker as an employee (when they are one) and consequently don’t pay the required tax. In that case, you’ll be penalized by paying a larger sum (10% to 13% of the employee’s salary).
Alternatively, if you’ve accidentally paid too much tax, you can request a refund by applying to the IRS and refunding/reimbursing the employee. However, this application must be made within three years of the date the original tax return was due. If not, the employer will have to refund the employee from their own funds.
What’s a W2 Employee?
Put simply; a W2 employee is an employee for whom the employer is required to report the employee's wages and other compensation on a W2 form. W2 employees are considered employees of the company when they receive a regular salary and benefits from an employer. (See our common law employee definition above.)
The IRS expects employers to send a W2 for:
“Every employer engaged in a trade or business who pays remuneration, including noncash payments of $600 or more for the year...or services performed by an employee”.
The W2 form should include any income, social security, or Medicare tax withheld in a given year.
It’s a legal obligation for employers to send W2 forms for every registered salaried employee within their company. (By law, as part of the hiring process in the US, an employee’s status must be submitted for verification to the IRS).
Lastly, it’s also worth noting that employees should receive a W2 from their employer at the end of the year. The IRS requires that you provide employee’s with a completed copy of your W2 form no later than January 31st.
What’s a 1099 Contractor?
In contrast, a 1099 contractor is a self-employed independent contractor. They’re paid directly by their client without their taxes being withheld. 1099 contractors are responsible for setting aside money for taxes and aren’t eligible for the same benefits as full-time employees. For instance, contract employees aren’t entitled to company health insurance, paid time off, retirement benefits, etc. (see the definition of independent contractor above).
A 1099 tax form is issued by the (IRS) to report various types of income other than wages, salaries, and tips. This includes income from independent contracts, royalties, dividends, and other income sources.
Businesses should provide 1099 contractors with a 1099 form to complete. Companies must submit this form to the IRS if they pay the independent contractor more than $600 in a given year.
W2 Employees vs. 1099 Contractors: What Are the Differences?
The differing status of a W2 employee and 1099 contractor (usually) depends on three factors:
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Behavior. Whether the worker has control over what work they do and when.
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The relationship between parties. i.e., the nature of written contracts, whether the worker receives employee-type benefits, whether the relationship continues after the service is provided, and/or if the service makes up a vital aspect of the recipient’s businesses.
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Finances. How their finances are managed.
There’s no rule for which category an employee falls under. However, the above factors should be used as criteria when deciding which category a worker falls under. So let’s look at each to compare:
Both W2 employees and 1099 contractors are paid for the services they provide. However, there are some key differences:
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For W2 employees, the employer controls how the specified work is completed. For example, an employee couldn’t supersede the owner's input on a project or decide to work on their own projects on their employer’s time. In contrast, where 1099 contractors are concerned, although the person paying for the service has a say in the outcome of the work, they can’t dictate how the job is completed. For example, let’s say you’re a contract worker for a graphic design project. In this scenario, it’s usually assumed that the designer can create the work independently using their experience and tools. The recipient of the service might request alterations and set a deadline, but they can’t dictate the contractor's work process or the specific hours the designer works.
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W2 employees have an employer-employee relationship with the business they work for, whereas 1099 contractors don’t. For example, When an independent contractor completes a service, they’re no longer under any contractual obligation to work with that company. Whereas an employee who completes a task is still considered a worker of that given organization.
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W2 employees fall under the employer's duty of care and have employment rights. For instance, having a safe environment to work in and restrictions on working hours. These same rights don’t automatically apply to 1099 contractors.
Should I Hire W2 Employees or 1099 Workers?
Now that we've covered the difference between each worker type, how do you pick the right choice for your company?
Pros of Hiring W2 Workers:
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You have full control over how employees complete the work you set them.
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As W2 workers tend to work for just one company, you’re better positioned to inspire a greater sense of loyalty.
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You can choose to offer employees professional development and career growth so that you know firsthand that you’re nurturing highly skilled employees over time.
Cons of Hiring W2 Workers
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In the long-run, permanent W2 workers tend to cost more (wages, benefits, etc.)
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Due to a lack of flexibility, W2 workers might suffer lower levels of job satisfaction.
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As W2 workers have more rights, there’s a greater risk of legal liability.
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It’s harder to scale your workforce up or down because you're often bound by stricter contracts and financial restraints.
Pros of Hiring 1099 Contractors
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You get exactly what you pay for, as you only remunerate 1099 contractors for the specific job they complete- not the hours they’re contracted to work.
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You enjoy greater flexibility, as you can hire 1099 contractors to work as and when the need arises.
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Contract workers might possess skills that your full-time employees don’t, making 1099 contractors a viable option for plugging skills gaps.
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There’s no long-term employment relationship, which lends itself to more flexibility.
Cons of Hiring 1099 Contractors
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You, as the employer, are responsible for obtaining the necessary paperwork (usually a 1099-MISC or 1099-NEC form) and overseeing your freelancer contract.
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Contracts can be terminated by either party at any time, which in some instances, can cause a lack of stability.
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You don’t have as much supervision over the contractor’s work.
So which is better? Well, that depends on the nature of your business. However, if you’re looking to expand your workforce this year (2023), you might already know there’s a severe shortage of skilled workers. In fact, 71% of CEOs anticipate skill gaps to be the greatest threat to business productivity in the years to come. Given this shift in the labor market, freelance and contract workers could be invaluable assets. After all, hiring highly skilled freelancers for short-term projects is often much faster than hiring traditional full-time employees. Interestingly, SHRM reports that it can take an average of 36 days to fill a traditional role. But by using freelancers, you can cut this down to an average of three days.
How to Comply With the IRS’s Employee Categories
The first step is to carefully evaluate the worker’s position to ensure it meets the definition of an independent contractor, including the worker’s contract and the terms it offers.
There’s no set contract that you’re obliged to use when working with freelancers. However, for tax purposes, it’s essential that you’ve clearly defined your relationship in writing and that both parties have signed the freelancer contract. I.e., you’ve clarified that it’s not an employee-employer relationship; instead, it’s a contractor-client arrangement.
Your contract should also specify the following:
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The scope of the project
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The expected duration of the project
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Your agreed-upon payment schedule
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Ownership of the end project and licensing
In addition to issuing contracts, you also need a system to properly:
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Withhold taxes (in the case of w2 employees)
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File the correct tax forms
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Pay contractors per applicable laws (payment laws vary from country to country)
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Where 1099 contractors are concerned, you’ll need to calculate the total sum of the invoices you paid to each contract worker and enter this into your 1099 form.
It’s also essential to provide clear instructions to freelancers to ensure they can easily submit their invoices. Equally important is that you pay promptly so it can be noted on the 1099.
Finally, we recommend that businesses consult with a compliance professional to stay up-to-date on the latest regulation when hiring contract workers and/or W2 employees.
How Can Bubty Help?
If staying compliant sounds overwhelming, Bubty can help get your system in order. Our freelance management system allows you to remain in control of your compliance by providing automated time tracking, payment processing, and invoicing. All this empowers you to accurately keep tabs on your freelancers' time and payments, ensuring you’ve paid the correct amounts and recorded said payments on your 1099.
You can store and organize all compliance-related and financial documentation within a secure cloud-based repository, eliminating constant back-and-forth emails with your contractor. You’ll also benefit from our contract signing tool and integrated chat functionality. Both of these can assist you with defining your relationship with your contractor to avoid misclassification.
But Bubty is more than just compliance management. To find out what we’re all about, visit us today for a discovery call.
