You may be considering cutting back on the number of full-time employees (W2 employees) and using contractors (1099 employees) to do the work at fixed rates and without paying benefits.

Many businesses have done just that. The Bureau of Labor Statistics counts 10.6 million independent contractors representing nearly 7% of total employment.  It’s estimated companies using independent contractors have increased by as much as 40% in the past decade.

There are significant differences in how you classify and treat W2 employees and 1099 workers. Knowing those differences is crucial to avoiding fines, tax penalties and other legal issues.

What Is a W2 Employee?

A W2 employee is someone you hire and put on the payroll.  The litmus test the Internal Revenue Service (IRS) uses to classify someone as an employee is when the business controls what work will be done and how it will be done. Even if you give the employee broad discretion in how to do the job, you have the right to control the details of how the service is performed. That means this person is your employee.

For a W2 employee, you are required, per IRS rules, to withhold income taxes, Social Security and Medicare taxes, pay unemployment insurance and pay workers compensation on wages paid to an employee. You will also need to provide W2 statements to the employee at the end of each year and report their wages to the IRS.

What Is a 1099 Employee?

To be clear, there is no such thing as a 1099 employee.  They are independent contractors that must meet specific requirements.  To qualify as an independent contractor, businesses can only control or direct the results of the work. Companies can’t control what will be done to deliver the results or direct how the work is to be done.

If they don’t meet this threshold, you can’t call them an independent contractor or report their pay on a 1099 form. They would be employees subject to tax withholding, and you would need to provide them with a W2.

In short, independent contractors are operating as an independent business.  Generally, you are not required to withhold taxes, and the contractor is responsible for paying any taxes, such as the self-employment tax.  You will need to provide them with a 1099 Form which they will use to report their income.

A 1099 employee and W2 employee tax form

1099 vs. W2 Employee

In an employment situation, the business calls the shots.  They will determine how employees work, when they work, what they can do (and can’t do), what performance is acceptable and the rate of pay.  A W2 employee is someone that might work in your office, using a desk and computer you provide and be assigned to a specific shift.  They work on an ongoing basis for your company, and you control how they do their work.

An independent contractor calls his shots.  They exercise independence in how the job gets done and the rate of pay.  They are responsible for outcomes, not process.  An example of a 1099 contractor might be an electrician or plumber you hire to fix a problem at your business.  You tell them what you want fixed, but they rely on their expertise to complete the job to your satisfaction.

They use their tools and decide how to get the job done.  They are doing a job for you, and when they are done, the engagement is over.

1099 employee rules state that an independent contractor is not subject to minimum wage and overtime.  They are not covered by workers comp and unemployment insurance.

When deciding how to classify workers, the burden is on you as an employer.  The law presumes workers are employees unless they meet the strict requirements for being an independent contractor.

Advantages of W2 Employees

W2 employees work for you.  They do what you need in the manner you want it done.  They are more committed to your company and offer more continuity. With independent contractors, you aren’t their sole focus as they are free to work with other clients.

You can shift employees to other jobs and tasks as business dictates. Independent contractors are hired for specific purposes.

Advantages of Independent Contractors

Independent contractors offer greater flexibility.  You can hire them for specific projects.  Once complete, you no longer engage or pay them.  With employees, you need to continue to pay them or terminate them.

They may provide expertise your employees may not possess. You may be able to lower your business costs because you don’t have to provide benefits or overtime.  There’s also less paperwork since you don’t have to withhold taxes.

Common-Law Rules

In determining whether someone is an employee or independent contractor, the IRS will look at evidence of the degree of control and independence in three categories:

  1. Behavioral: Does the business exercise control or have the right to control what the worker does and how the worker does their job?
  2. Financial: Are business aspects of the worker’s job controlled by the payer? This might include how a worker is paid, whether job-related expenses are reimbursed and who provides the tools needed to do the job.
  3. Relationship: Is the work performed a “key aspect” of the business?  Is the relationship permanent?  Are there written contracts or benefits, such as insurance vacation, pay or pension plan that are consistent with being an employee?

If you are uncertain whether someone qualifies as either an employee or an independent contractor, you can ask the IRS for clarification.  There’s a form for that, but it can take several months to get a determination.

W2 employee submitting a claim for workers compensation

Do 1099 Employees Need Workers Comp?

The answer to this question depends on your state laws.  Some states require worker compensation for all employees and contractors.  Others do not.  Some states will also require workers comp for contractors in certain industries, such as construction workers at job sites.  You should check with your state’s Department of Labor on the rules and regulations.

How to Pay 1099 Employees

When an employee starts work, they fill out a W4 form. An independent contractor will provide you with a W9 form that includes their tax ID or social security number. You can pay independent contractors in any method you choose.  In most situations, you would not withhold taxes.

It’s a good idea to have a 1099 employee contract that spells out the details of both compensation and scope of work.  If the job involves intellectual property or may have liability concerns in the future, a contract is critical.

For each independent contractor that you paid $600 or more during the year, you must report the amount you paid on IRS Form 1099 at the end of the year.  A copy goes to the contractor for filing their taxes.  You will also have to submit IRS Form 1096, which summarizes all of your 1099s.