As a business owner, it is of the utmost importance that you have a basic understanding of how to classify people who work for you. More specifically, you need to know the difference between workers that are your employees and ones that are independent contractors and how this may impact your hiring strategy moving forward. Even if you have a payroll service or accountant that manages your finances and wages, every small-business owner should be able to differentiate between these two types of workers. How the workers are taxed, and how you account for their wages and your taxes, depends on whether your workers are employees or independent contractors. You won’t be able to decide whether to hire employees or contractors until you understand the difference between the two as there can be large implications to your business. Once you do, you can determine which type could be the better fit for your business. Read on to find out the difference between a 1099 worker and W-2 employee.
There is a fundamental difference between 1099 workers and W-2 employees. First, 1099 workers are self-employed independent contractors. They get paid per the terms of their contract. For tax purposes, they receive a 1099 form to report income on their tax return. In contrast, a W-2 employee receives a regular wage, like a salary, and employee benefits, such as insurance. Taxes are taken out of a W-2 employee’s paycheck and reported to the IRS on a W-2 form. As a small-business owner, however, you need to understand further what defines a 1099 versus W-2 employee to appreciate the payroll and tax implications. Related: W-2 vs. W4 — What's the Difference?
A 1099 worker is a self-employed independent contractor. Sometimes these types of workers will refer to themselves as freelancers. Others will be part of a more fully built-out business. Either way, when you hire an independent contractor, you enter into a contract with them to do a specific role or complete a specific task. In general, contractors may set their own hours and use their own tools, though there may be exceptions. Commonly, independent contractors work for more than one business, unless terms like noncompete clauses are agreed to. Since independent contractors are self-employed, you do not withhold taxes from their paychecks. Instead, they pay their own taxes and report their income via the IRS’s 1099 form. As a business owner, you also don’t provide 1099 workers with benefits; they are responsible for their own insurance. Read Next: 10 Business Owners Share Their New Year's Resolutions for 2020
A W-2 employee is hired by your business under an employment agreement. As a business owner, you withhold taxes from employee wages, such as federal and state income taxes, as well as Social Security and Medicare, and any other relevant taxes. Typically, you also train W-2 employees , pay employment taxes for them — which occur on each paycheck — and you may also provide benefits. Due to these features, you have more control over your W-2 employees, deciding what they work on, their hours and conduct toward other employees.
If you have employees, you’ll use a W-2 tax form to report annual compensation and payroll taxes you withheld from their compensation. Payroll taxes require employers to collect taxes from employees throughout the year, with money taken out in each paycheck. The collected taxes are then added up and detailed on a W-2 form. As a small-business owner, you must mail W-2 forms to your employees by Jan. 31 of the following calendar year. W-2 forms are available through the IRS website. As a business owner, however, it’s advised to enlist the help of payroll services or software to automate this whole process. Copies of the W-2 go to the Social Security Administration; state, city or local tax department; the IRS; your employee and also to you, the employer, for your records. If you are hiring an independent contractor, the IRS form to use is Form 1099-MISC, Miscellaneous Income . A 1099 form is actually a series of documents that you’ll use to report payments made to an independent contractor. An individual or business that pays an independent contractor $600 or more in a calendar year is responsible for sending the contractor a completed 1099-MISC (Copy B) by Jan. 31 of the following calendar year. In some cases, there are exemptions that exclude some independent contractors from needing to be reported (i.e., if the recipient was a corporation). When you send a contractor a 1099-MISC (Copy B), you’re also responsible for filing the 1099-MISC (Copy A) with the IRS by Jan. 31 of the following calendar year. To get these forms, you can order free hard-copy 1099-MISC forms from the IRS. However, it is far more efficient for you to buy or hire payroll services to automate and handle all this electronically.
There’s no one right answer to the question of whether to hire a 1099 worker versus a W-2 employee. Really, this decision comes down to the circumstances of your business, your business objectives and vision for where your business will go . It also boils down to questions of whether you need a specialized project or job completed, or if your business needs are more ongoing than just one or two tasks. Here are some of the drawbacks and advantages of both 1099 workers and W-2 employees for your business.
Outside of how they’re taxed, the difference between an employee and an independent contractor largely boils down to the degree of control you have over the worker versus the amount of independence the worker has. This fundamental criterion is, unfortunately, a bit vague. The Fair Labor Standards Act, which governs relationships between you and your workers, doesn’t define it either. Instead, you need to look to the IRS for answers. The IRS looks at three categories of criteria to help you determine the degree of control or independence you have with your workers. According to the IRS , these include the following:
Even with these criteria, there’s still no simple formula or test to determine if a worker is a 1099 contractor or W-2 worker. To figure it out, look at the entire relationship between you and your worker — or potential worker. Ask yourself to what degree you direct the individual’s work. On the other hand, determining which type of worker could be clear-cut if an independent contractor provides you with a standardized contract for hiring them. As you determine whether a worker is an employee or a contractor, be sure to document all the factors you considered that led you to this decision. A critical legal point to note is that, in most cases, the law presumes workers are your employees unless they meet strict legal requirements that establish them as independent contractors. More From Seek
Business Loan Resources
Photo credit: Ievgenia Tiiechko/Shutterstock.com