1099 VS W-2 Employees: Which Is Better For Your Small Business?
Congratulations! You’re starting or expanding a business and it’s time to add new employees to your payroll. Before you hire employees to keep your business running smoothly, though, there’s one burden that you must tackle first: determining whether to hire 1099 or W-2 employees.
Each type of employee has its own set of pros and cons. There are different tax implications for each, and there are different forms that you and your new employee will need to fill out. In this post, we’re going to eliminate the confusion. We’re going to look at the differences between 1099 and W-2 employees, answer some of the most frequently asked questions, and help you determine which type of employees you should hire for your business. Keep reading to learn more.
Table of Contents
- The Key Difference Between 1099 & W-2 Employees
- What Is A 1099 Employee?
- What Is A W-2 Employee?
- Why Knowing The Difference Between 1099 VS W-2 Matters
- Should You Hire A 1099 Or W-2 Employee?
- Already Have Workers? Here’s How To Determine If They Receive A 1099 Or W-2
- Which Do Employees Prefer: 1099 Or W-2?
- 1099 VS W-2 Employees: The Bottom Line
- FAQs About 1099 & W-2 Workers
The Key Difference Between 1099 & W-2 Employees
There are a number of distinct differences between 1099 and W-2 employees. A 1099 employee is a more temporary solution to staffing issues. These employees are self-employed and receive a Form 1099 for tax purposes. A W-2 employee, on the other hand, holds a more stable and permanent position within your organization. These employees receive a W-2 for tax purposes. There are additional differences between the two, which we’ll discuss in more detail throughout this post.
What Is A 1099 Employee?
A 1099 employee is also commonly known as an independent contractor or freelancer. A 1099 employee is self-employed and may perform work for one business or several. Despite the title, these individuals are not employees of your business or any other business for which they perform work. As a result, they are not paid a salary or entitled to benefits offered to your W-2 employees.
1099 employees are paid based on the contract or written agreement you have in place. The contract may be for a single job or several. There are a number of reasons that businesses use 1099 employees. For instance, a business may need temporary help to finish a large project, or a company may employ someone with specialized skills who isn’t needed on a full-time basis.
Come tax time, 1099 employees will receive IRS Form 1099-MISC, which they will use to report self-employment income and pay self-employment taxes. A 1099-MISC must be issued to any contractor, freelancer, or other self-employed individuals that made at least $600 performing work for your business.
What Is A W-2 Employee?
A W-2 employee is actually an employee of your business. This person will receive an hourly wage or salary that is agreed to upon hiring. Additionally, a W-2 employee is entitled to benefits offered by your business, including but not limited to health insurance, retirement plans, and overtime pay. Your W-2 employees may work full-time or part-time based on the agreements you’ve made upon hiring.
You will be required to withhold federal income taxes from your W-2 employees. Additionally, you will withhold and match employees’ Social Security and Medicare taxes. You will also be required to pay unemployment taxes for your employees. IRS Form W-4 is used to determine the correct amount of federal income tax withholdings for each employee.
At tax time, you will issue IRS Form W-2 to each of your employees. These forms will then be used by the employee to prepare and file their income tax returns.
Why Knowing The Difference Between 1099 VS W-2 Matters
It’s important to take the time to understand the difference between 1099 and W-2 employees. Failing to properly classify your employees can result in high costs and hassles for your business. Keep reading to learn more about why correctly classifying your employees is critical for the success of your business.
To Avoid IRS Penalties & Lawsuits
Misclassifying your employees can be a very costly mistake for your business. If a W-2 employee is misclassified as a 1099 contractor, the IRS can fine your business for each W-2 that wasn’t filed and impose penalties on wages. Additionally, you may be required to pay unpaid Federal Insurance Contributions Act (FICA) taxes. These penalties can be extremely costly, especially if you have an employee that’s been misclassified for a long period of time or multiple misclassified employees.
If you’ve misclassified W-2 employees as 1099 contractors, there can also be financial penalties. Your employee can sue you if they feel they were wrongfully denied minimum wage, overtime pay, or benefits provided to W-2 employees within your business.
To Withhold The Right Amount Of Taxes
Failing to withhold taxes from your employees can result in your business paying back taxes — along with additional penalties that could leave you with a hefty tax bill.
For your 1099 employees, you will not be required to withhold taxes from their paychecks. In addition, you also do not have to pay income taxes or your share of Medicare and Social Security taxes for these employees. You also are not required to pay unemployment taxes for 1099 employees. Since 1099 employees are self-employed, it is their own responsibility to file and pay taxes on the wages they’ve earned.
On the other hand, you will need to withhold and/or pay taxes for your W-2 employees as follows:
- Federal Income Taxes: This is calculated based on the employee’s W-4 form. The employer withholds these funds from the employee’s paycheck and remits these payments to the IRS.
- State Income Taxes: The employer withholds state income taxes from W-2 employee paychecks and remits these payments to the IRS.
- FICA Tax: FICA tax — Medicare and Social Security tax — is collected from employee paychecks. The employer also matches these payments.
- Unemployment Taxes: Unemployment taxes are paid by the employer alone. No funds are withheld from employee paychecks.
As you can see, taxes for your W-2 employees are much more complicated than for 1099 employees. While it may be tempting to try to avoid withholding and paying taxes by simply classifying your workers as 1099 employees, this mistake can be extremely costly. In addition to paying back taxes, you may be subject to penalties including but not limited to:
- $50 fine for every W-2 that wasn’t filed
- 40% of FICA taxes that weren’t withheld
- 100% of your share of FICA taxes
- 0.5% of your unpaid tax liability each month (maximum 25%)
To Save You Money
Hiring a W-2 employee can be expensive. In addition to the taxes you’ll be required to pay for that employee, you also need to take into account other expenses, such as training and onboarding.
While this makes sense for employees that are involved in your company’s day-to-day operations, it’s not ideal for every situation. For instance, it may not make sense to hire a W-2 employee for a short-term project with a quick turnaround time or for a specialized role for a one-off project.
In these situations, it makes far more sense to hire a 1099 employee to temporarily alleviate staffing or skills shortages without having to pay payroll taxes or spend time and money training and onboarding someone new.
To Attract The Right Employees
What kind of employees are you looking for? The answer varies from business to business, so it’s important to take stock of what your business needs. If you have projects with quick turnaround times and only need temporary help, 1099 employees may be the best fit for your business. On the other hand, if you prefer to have loyal employees that work consistently over the long term to help keep your business running, W-2 employees are likely the better option.
Should You Hire A 1099 Or W-2 Employee?
Are you ready to hire employees, but you’re not sure which type you need for your business? Here’s how to decide — and keep in mind that many businesses use a combination of 1099 and W-2 employees.
The Pros & Cons Of 1099 Employees
There are a few advantages to hiring 1099 employees. You will not be required to withhold and pay payroll taxes for 1099 employees. You are also not required to pay a salary or provide benefits to these employees. For short-term projects, you can save quite a bit of money by using 1099 employees.
Once the terms of the agreed-upon contract have been filled, the independent contractor is free to take on other projects with other businesses. You do not have to worry about firing or laying off the employee, which can be stressful for all parties involved.
There are downsides to using 1099 employees, though. You have less control over independent contractors. For example, the 1099 employee can choose his or her own hours provided that their work is completed within the set deadline. The employee can also choose how they complete the work, even if it’s through a method that’s different than what you expect. This can be a slippery slope for employers, as trying to set hours or dictate how work is completed crosses over into W-2 employee territory and can result in misclassification, tax penalties, and having to pay lost wages and benefits to the employee.
- Offers staffing flexibility
- Less expensive than hiring a W-2 employee
- No firing or layoffs
- Ideal for short-term work, specialized jobs, or one-off projects
- Lack of control over hours or how work is done
- Employee may not be available for future projects
The Pros & Cons Of W-2 Employees
W-2 employees are going to help you tackle the day-to-day operations of your business. These are the employees that earn a salary or hourly wage and receive benefits offered by your company. You can set hours for your W-2 employees, as well as train them on how to properly do their job.
Your W-2 employees will also be more loyal and consistent. You won’t have to worry about them taking on new clients and being unable to perform work for your business. Additionally, you can offer benefits that increase employee morale and better attract high-achieving, hard-working, and committed employees.
These benefits, though, come at a cost. Employment taxes also add to the costs of hiring a W-2 employee. You (or other staff members) will also have to take time to onboard and train your employees.
You’ll need to be careful to ensure that you meet all employment laws as well, which can get complicated. This includes:
- Minimum wage & overtime pay
- Family & medical leave requirements
- State workers compensation requirements
- Withholding & paying employment taxes
You also need to consider what happens when it’s time to separate from the employee, whether it’s due to budget cuts, lack of work, or employee performance. You will have to lay off or fire the employee, making sure that you understand the legalities associated with these actions.
- More control over employee hours and how jobs are completed
- Increased loyalty & commitment
- Ideal for long-term work
- More expensive
- More time required to find, onboard, and train employees
- Firing or laying off employees may be necessary
Choosing The Right Employee Structure For Your Business
With a better understanding of W-2 and 1099 employees, the next step is to determine which employee structure is better suited for your business.
1099 employees are better suited for short-term needs. W-2 employees are the better fit if you need consistent, loyal employees to perform work over a longer period of time.
Let’s take a look at a few specific examples to help you determine what employees to hire for your business.
|The Problem||W-2 Employee||1099 Employee|
|Your project requires design, but you don’t have an in-house graphic designer. You do not regularly have projects that require design.||In this situation, hiring a specialized independent contractor is the most cost-efficient and fastest way to complete your project.|
|You’re a sole proprietor that has taken on too many projects. You need someone to take on some of the projects until you’re caught up.||The best solution in this situation is to outsource your extra work to an independent contractor.|
|You own an ice cream parlor that operates year-round. However, business significantly increases during the warmer months, and you need additional staff.||Businesses that have seasonal increases should hire W-2 employees, even if the employee is only needed for the season or on a part-time basis. This will legally allow you to set hours for the employee and ensure that they are trained properly on your business procedures.|
|You have been hired to take on a project, but you can’t meet the deadline with your current staff. You need an employee that can help finish the project on time.||In this scenario, you can hire an indepedent contractor to help finish the project. Make sure a contract with deadlines is in place, and also remember that you will be unable to set a 1099 employee’s hours or dictate how the work is completed.|
|You’re ready to hire new employees, but you want to give them a trial period to make sure it’s a good fit.||If you plan to have your new employees report to work at a certain time, go through training, and follow your business procedures, you will need to hire W-2 employees. This is true even if the employee doesn’t continue past the training period.|
|Your business is booming, and you no longer have time to tackle accounting. You need someone to maintain the books regularly, but you don’t need a full-time employee.||If you have a recurring job that needs to be performed on a part-time basis, such as weekly bookkeeping, you can hire a 1099 employee to tackle this task.|
|You want permanent, stable, and steady employees that come to work at set hours and perform duties assigned to them.||For this scenario, W-2 employees are a permanent solution to staffing issues. W-2 employees can help you complete daily operations.|
Already Have Workers? Here’s How To Determine If They Receive A 1099 Or W-2
Unsure if you’re classifying your employees correctly? To avoid those penalties and potential lawsuits we discussed earlier, we can look right to the IRS to determine how to properly classify your employees.
The IRS outlines three categories to consider when classifying your employees: Behavioral Control, Financial Control, and Relationship.
Your employee may be a W-2 employee if:
- You set your employee’s hours and require the employee to be in a specific place during that time (i.e., your retail store or office building)
- You require your employee to use or purchase specific supplies or equipment to do their job
- You require training or provide detailed instructions for how to complete the job
Your employee may be a W-2 employee if:
- Your company reimburses them for travel and other expenses
- You pay them an hourly wage or salary on a regular basis (i.e., weekly or bi-weekly). Most 1099 employees work for a flat fee per project.
- Your business has a significant investment in the tools and supplies needed to complete the job
- The employee works only for your company and does not provide services to multiple businesses
Your employee may be a W-2 employee if:
- The employee is provided with benefits, such as health insurance, a retirement plan, or vacation pay
- The relationship between you and the employee is indefinite. In other words, you will continue to use the employee on a regular basis rather than for a specific period of time.
- The employee can terminate their employment at any chosen time. A 1099 contractor can only legally do so if allowed under their contract with your business.
These are just a few things to consider when determining whether you have 1099 or W-2 employees. Note that all conditions outlined above do not have to be met in order to determine the status of your employees. Let’s say, for example, that you require an employee to be in the office Monday through Friday for a set period of time. Even if no other conditions from the bulleted lists apply, this employee is still considered a W-2 employee.
If you’re still unsure or you have a unique situation not covered in this post, the IRS has a load of resources at your disposal to help you determine the status of your employees.
Which Do Employees Prefer: 1099 Or W-2?
Every person has their own goals for their career, so the preference for being a 1099 or W-2 employee depends on who you ask.
Many people like the flexibility of being an independent contractor. They can choose their own clients, take on the projects that interest them the most, and set their own rates and terms. A person that likes doing many different jobs, taking on specialized work that fits their skill set, and having the freedom to complete work when they want using their own methods would likely prefer being a 1099 employee.
On the other side, we have workers that would prefer to be a W-2 employee. They want steady employment that comes along with a steady paycheck. They don’t want to seek out their own clients and projects. They understand that their employer has the upper hand when it comes to when they work, how much they get paid, and how tasks are performed in the workplace. People that want stability with one employer don’t want to worry about tracking expenses and paying self-employment taxes, and are comfortable with being managed would likely prefer being a W-2 employee.
1099 VS W-2 Employees: The Bottom Line
By determining the needs of your business first, you can better decide whether to hire 1099 or W-2 employees — or maybe even a combination of both. 1099 employees are a good choice for your business when you have short-term projects or require a specialized skill set to get a project out the door. While you won’t be able to control when or how the employee works, you’ll avoid time-consuming training and can avoid paying employment taxes.
However, if you need employees for a longer period of time and need them to be at a specific job at a specific time doing work according to company procedures, you need to hire W-2 employees. Yes, hiring and training can be time-consuming. Yes, you will be required to pay employment taxes. However, doing everything by the book can help you avoid costly lawsuits or tax penalties that can severely impact your business.
Hiring and classifying 1099 and W-2 employees is stressful enough, but then comes payroll. Fortunately, running payroll doesn’t have to be daunting — not when you use payroll software. If you have employees or plan to hire in the near future, don’t do your payroll the old-fashioned way. Instead, check out our picks for the best payroll software for small businesses to save time and make sure your employees and contractors are paid on time every time. Good luck!