Play an audio version of this article
We get it: trying to decipher the differences between 1099 vs W2 employees for small businesses can be confusing. However, it's critical you have at least a basic understanding of how to classify different workers.
Even if you use an accountant or a payroll service to manage your payroll, it behooves you to understand the relationship. Why? Because whether you have independent contractors or employees has significant implications into how your business is taxed. And misclassifications can lead to hefty fines, lawsuits, and back payments. Let's take a closer look at 1099 vs W2 employees and what it means for small businesses.
In short, the 1099 and W2 are two different tax forms utilized to deduct payroll taxes for different types of employees. You will either file a Form W2 on behalf of your employees or provide a Form 1099-MISC to independent contractors who work for your company.
A W2 employee is the standard type of employee who receives a regular wage or salary as well as employee benefits. With a W2 employee, you are required to withhold income taxes from their paycheck and will retain a substantial degree of control over their work.
On the other hand, 1099 employees are independent, self-employed contractors. These employees are paid based on their contract term and receive a 1099 form to report their earnings on their tax returns.
Whether you call them a freelancer, independent contractor, or a consultant, these workers are typically self employed and should be provided a Form 1099. In most instances, independent contractors will provide a specific set of services, and some may only work on a single project at a time. Some independent contractors will serve several clients at the same time.
The majority of the time businesses will hire standard W2 employees with hopes of establishing a long-term relationship for an extended, undetermined amount of time. In contrast, businesses commonly use freelancers, independent contractors, or other 1099 workers with a clear end in mind, which may be outlined in the terms of the contract. You can, however, renew the contract and relationship as many times as you and the 1099 employee agree to.
Because these people are self-employed, they are in fact business owners themselves. As a result, 1099 workers can opt to hire their own team of workers to help them deliver the service or product you partnered with them to provide. Simply put, independent contractors, consultants, freelancers or other 1099 employees are responsible for their own loss or profit when they complete jobs.
When you contract a 1099 worker, you will have a certain level of reduced oversight. At the same time, you will have reduced legal responsibility and financial responsibility. 1099 contractors are responsible for paying both employer self-employment taxes as well as employee taxes.
This makes 1099 contractors a very attractive option for small business because you will not be required to pay payroll taxes. In addition, 1099 workers typically are not eligible for the benefits you make available to your W2 employees, such as vacation, paid time off, health insurance, etc.
When you think of a standard employee, you're more than likely envisioning a W2 employee. These employees are not business owners. They actually work for your company and offer availability based on the needs of your business.
Federal and state laws mandate W2 employees are paid a minimum wage for the hours they work on a regular and ongoing period. You will be required to withhold their Medicare taxes and Social Security taxes from their pay. You will also be required to pay employer payroll taxes. And employee benefits are offered to this group of employees.
It's extremely important you properly classify your employees as either W2 employees or 1099 workers with the IRS. For many businesses, simplicity and savings the key driving factors used to decide whether to hire an employee or engage a contractor. Frankly, it's significantly easier to pay a 1099 worker than it is to manage payroll and the bevvy of other HR functions associated with hiring W2 employees.
However, the savings of money and time will quickly disappear into thin air if the Department of Labor or IRS catch wind of misclassified workers through an audit. If they determine you have misclassified workers, they can mandate penalties and levy back taxes that exceed 40% of the 1099 workers pay. And the Department of Labor can make you pay wages up to three years retroactively.
At John F. Dennehy CPA, we are a team of experienced accountants skilled at helping businesses with a variety of matters, including:
If you have questions about the classification of W2 employees vs 1099 contractors, contact John F. Dennehy CPA today.