1099 VS W-2 Employees: Which Is Better For Your Small Business?

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 as a result of a lawsuit. 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.

Failure 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.

Since 1099 employees are self-employed, it is their own responsibility to file and pay taxes on the wages they’ve earned. For your 1099 employees, you are not required to:

• Withhold taxes from their paychecks
• Pay income taxes for these employees
• Pay the employer’s share of Medicare and Social Security taxes for these employees
• Pay unemployment taxes for these employees

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%)

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.

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.

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 also drawbacks to using 1099 employees. You have less control over independent contractors. 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.

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.

However, these benefits 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 worker’s compensation requirements
• Withholding & paying employment taxes

Running payroll can also be complicated, but fortunately, this burden can be alleviated for both W-2 and 1099 employees with the use of payroll software.

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.

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.