As you grow your organization, you’ll need to hire more people. This means negotiating pay and benefits. But did you know that employee classification affects taxation and the benefits you have to pay on their behalf?
There are generally two types of hires: independent contractors and full-time hires. These two groups are taxed differently and are entitled to different benefits. As an employer, you need to provide a 1099 for your independent contractors and a W2 for your full-time employees.
What’s the difference between 1099 vs W2 taxes and how should you decide if an employee is an independent contractor or a full-time employee? Here’s everything you need to know.
How workers are taxed depends on their employment classification. Therefore, it’s important to understand the difference between an independent contractor who is employed on a contractual or project basis and an employee who works full-time:
Independent contractors are considered self-employed individuals who enters into a long or short-term freelance contract with a business. They have a very specific job description that focuses on specific tasks or the performance of a specific role for a single project.
They determine their own work hours, use their own tools, and are free to work for multiple businesses or organizations simultaneously.
Additionally, independent contractors or self-employed individuals pay their own taxes and are responsible for their own benefits.
Organizations or businesses that hire employees can dictate their work hours. In addition, the company provides the tools or equipment required to complete the tasks that are outlined in the employee’s job description and can dictate how they work.
They may also have to train and provide benefits to the employee.
In addition, the company should pay employment taxes on behalf of the employee by withholding a certain amount from their wages.
The distinction between a freelance contractor and a full-time employee goes beyond the scope of work, job description, and payment. They also affect how you pay taxes as their employer which is where the distinction between 1099 vs W2 taxes comes into play.
1099-NEC refers to an IRS form that mentions how much a nonemployee worker like a freelancer or independent contractor was paid by a company. It lists all the payments or compensations during a tax year that were paid to an individual who is responsible for remitting their income tax.
The 1099-NEC also lists any federal, state, and local taxes that may be withheld by your company which are nil in the case of an independent contractor.
A 1099-NEC is filed for workers who are paid a minimum of $600 for their services and have had no taxes withheld based on their employment agreement.
To gain a general understanding of the type of workers who are typically classified under the 1099 taxation category, here are some examples:
- Freelancers who work on an assignment or project basis rather than with set hours (such as writers, designers, developers, event managers, etc)
- Consultants who offer advice or support for a particular project with an explicit beginning and end date to their contract
- Gig workers who are paid through an app for the services they perform whatever they may be
The W2 IRS form is a statement of an employee’s wages and taxes.
It is a record of the compensation, benefits, and taxes withheld from an employee for a given tax year.
A W2 is filled by a company on behalf of a worker who becomes employed (whether part-time or full-time) at any time during the year.
The W2 is filed for all employees who are paid at least $600 during the tax year and for employees whose taxes are withheld even if they are paid less than $600.
Here are some examples of W2 workers:
- Project managers who conduct team meetings and oversee ongoing projects
- Staff with scheduled hours who are required to work remotely or in-office on ongoing projects (such as writers, developers, designers, etc)
- Delivery drivers who use a company vehicle or signage and work on scheduled hours and routes
To know whether taxes should be withheld from a worker’s wages or not, it is important to know a worker’s classification.
So, how can you tell the difference?
The distinction between an employee and an independent contractor depends on the degree of control the company has over them. As vague as this description may seem, the IRS uses three categories to determine whether 1099 vs W2 taxes are applicable for human resources they hire.
The three categories that are used to classify workers are:
Does the company have control over how the worker does the job? This includes the schedule, location, tools, and methods used to conduct work and complete tasks. The more control a company has over these aspects, the more likely it is that a worker should be classified as an employee.
Does the company control how a worker is paid, or whether the worker can seek other jobs? If so, then the worker may be considered an employee rather than a contractor.
Is the company responsible for providing benefits like paid time-off, 401(k), or insurance? Are the services rendered a key aspect of the business? Is the job expected to go on indefinitely? Are there written contracts? If the answer is yes, you most likely have an employee.
While a contractual agreement that states whether a worker is an independent contractor who is responsible for their own taxes is important, it is not sufficient. A company must also document factors that led to how they decided to classify a person.
If you classify someone as a contractor when they’re really meant to be an employee, you will be liable and must pay for all the taxes and benefits that haven’t been paid. Additionally, you may incur common financial penalties such as:
- The reimbursement of wages that were not applicable before such as overtime and minimum wage
- Back taxes and penalties for income taxes, Medicare, Social Security, and unemployment
- Workers’ compensation for misclassifying employees
- Providing employee benefits like insurance, retirement plans, etc
Having W2 employees comes with its share of benefits and disadvantages. Knowing them will help you understand which type of worker would be beneficial to you.
- Benefits offered to W2 employees – paid training, healthcare, sick leaves, paid time off, and 401(k). These help attract and retain high-performing employees while improving workplace morale.
- Employees are hired for an indefinite period of time and won’t leave after a project is completed. This increases the number of consistent workers a company has.
- Employers have more control over an employee’s work.
- More expensive as employers have to pay for taxes, offer benefits, healthcare, etc.
- W2 employees have more legal protections and employers have to pay FICA, FUTA, and SUTA taxes, among other benefits.
- Employers must spend resources training and managing employees which is a more significant long-term commitment.
- Employers are not responsible for paying taxes on the contractors’ behalf/
- Contractors must provide their own benefits such as healthcare, paid time off, 401(k), etc.
- Employers do not have to train contractors to develop their skills as they are hired for their expertise and skill set.
- Employers have less control over the work that contractors do as they use their own tools and work on their own time.
- Contractors don’t stick around once the project is completed or the agreement period has lapsed. This could cause problems with consistency.
- There may be a lack of company loyalty as contractors are not obligated to work with just one company at a time.
- Contracts need to be thoroughly designed to protect your business.
- Organizing and managing contractors can be difficult.
The differences between 1099 vs W2 taxes as well as contractual and full-time employees are vast. Knowing which one to hire may seem confusing.
Hiring a contractor is a good idea if:
- You have a set assignment or project and can’t guarantee ongoing work after the project is completed
- If the work doesn’t require a set location or scheduled hours
- You don’t want to offer training and prefer to rely on a resource’s existing expertise
Conversely, hiring an employee is helpful if you:
- Have ongoing work
- Need them to use your equipment, follow company protocol, or work in a set location.
- Have work that requires management, oversight, and scheduled hours.
Knowing the differences between these two types of workers and your financial obligations towards them will help you hire additional people more efficiently while saving valuable time and money. You’ll avoid paying for costly fines as well as back taxes and benefits you didn’t realize you owed.