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 or ones that are independent contractors.

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. 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.

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Difference Between 1099 vs. 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?

What Is a 1099 Worker?

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.

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What Is a W-2 Employee?

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.

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Managing Taxes for 1099 Workers and W-2 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.

Do you have business tax questions? Check out our comprehensive guide to small business taxes for answers.

When to Hire W-2 vs 1099 Worker

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.

Pros of 1099 Workers

  • Flexibility: Typically, you hire independent contractors for a specific project, task or amount of time. Hiring these types of workers provides your business with more flexibility in hiring and dismissal, whereas hiring employees can be a costly enterprise in itself.
  • Cheaper for business: Since contractors are not classified as employees, you don’t have to withhold payroll taxes from their payments or provide benefits like health insurance. This can save a lot of money that would otherwise be spent as part of employee compensation.
  • Expertise and specialized skills: Contractors typically are well-trained in their field and have had experience working jobs before. As such, they usually require minimal or no training. They can focus on a particular project that you may not have expertise in and one in which hiring full-time employees would be inappropriate for.

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Cons of 1099 Workers

  • Less control: You’ll have less control over independent contractors, who tend to have a greater amount of autonomy than employees, though everything comes down to their contract. Since independent contractors usually only work for a business for a short period of time, they can inadvertently be disruptive.
  • Legal and contractual issues: The terms on which you work with independent contractors is entirely controlled by your contract. This is where, as a business owner, having a trusted legal professional read and review legal contracts closely can be very useful. Another consideration is that, while you can fire an employee at will, you might not be able to dismiss an independent contractor in the same way without being in breach of contract.
  • Insurance issues: You might not have to provide health insurance for contractors, but you need to pay attention to other insurance issues. For example, if an independent contractor gets injured on the job, he could choose to sue your business. With employees, however, you can cover them using workers’ compensation insurance and usually can’t sue their employer for work-related injuries as a result.

See: How Much Insurance Does Your Business Really Need?

Pros of W-2 Employees

  • Greater control: Employers have control over their employees’ schedules, what they work on and how they do it. If you need something done a certain way or want workers to contribute to your business goals in the long run, then it makes a lot of sense to hire an employee to do the job.
  • Loyalty: In general, your employees are going to show more loyalty toward you as a business owner —their ultimate boss — than an independent contractor. Employees often identify strongly with their job, value the financial security of a steady paycheck and may want to stay with your company for the long term more so than independent contractors.
  • Ongoing support: During busy periods, you can count on your employees to pitch in, work late and help get the job done. Employees can wear multiple hats and help out where they’re most needed.

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Cons of W-2 Employees

  • Managing employees: When you take on W-2 employee, you’ll need to train, manage and motivate them. This is the kind of job that often turns into a department in itself, so you need to assess how much time, energy and resources you can put toward hiring and managing employees.
  • Resources: A big difference between employees and independent contractors concerns resources and supplies. You need to supply your employees with everything they need to do their jobs, whereas independent contractors bring their own skills and tools. Employees are generally based on-site as well, which means you must make considerations for workspaces for your employees.
  • Higher costs: You’re responsible for employees’ wages as well as paying your share of their Social Security and Medicare taxes. On top of that, you often need to provide employee benefits like health insurance and paid leave, too.

Find Out: 26 Small-Business Tax Deductions That Will Save You Money

How To Determine If a Worker is 1099 or W-2

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:

  • Behavioral: Do you control or have the right to control what your workers do and how they do their jobs?
  • Financial: Are the business aspects of your worker’s job controlled by the payer, meaning you as the business owner. These aspects include things like how the worker is paid, whether expenses are reimbursed and who provides supplies or tools for them.
  • Type of relationship: Do you have written contracts or employee-type benefits, such as insurance, vacation, 401(k) and similar? Will the relationship with your worker continue or be permanent? Is the work that is performed a key aspect of the business?

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.

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