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1099 vs. W2 Employee: What’s the Difference?

As an employer, misclassifying workers (1099 vs W2 employee) means your company could be liable for employment taxes, back wages (including overtime), unemployment claims, workers’ compensation claims, violations of the FMLA, claims involving benefits, and more.1

It is critical that you correctly classify your workers and understand the differences between these two employment classifications and the implications they hold.

Types of workers

When it comes to taxes, the Internal Revenue Service (IRS) separates workers into two different categories: employees and independent contractors. It is up to the employer to determine whether the individuals providing services are employees or independent contractors.2

“Businesses and leaders need to be very clear that there are ‘employees’ and there are ‘independent contractors.”

Leah Babbitt, Human Resources Professional + Associate Vice President at the Cameron Group 

What is a W2 employee?

A W2 employee is what the IRS considers an actual employee of the company. The term “W-2” comes from the tax form employers provide their employees every year that summarizes their earnings and tax withholdings.

A W2 employee is considered an employee of a company in the most “traditional” way. They work under the direct control and supervision of the employer, who dictates their tasks, hours, and work conditions.

W2 Employee: Taxes

When it comes to W2 employees, employers must withhold and deposit income taxes, social security taxes, and Medicare taxes from the wages paid to an employee. They must also pay the matching employer portion of social security and Medicare taxes and unemployment tax on wages paid to an employee.3

W2 Employee: Benefits

W2 employees are also typically entitled to various benefits, such as health insurance, retirement plans, and paid time off. In fact, employers with 50 or more full-time and/or FTE employees must offer affordable health insurance to their full-time employees, or they may be subject to penalties.Click here to learn more: Ultimate Guide to Obamacare for Small Business Owners

W2 employees are covered by various employment laws, including the Fair Labor Standards Act (FLSA), which requires covered employers to pay their nonexempt employees at least the Federal minimum wage for every hour worked and overtime pay for every hour worked over 40 in a workweek.4

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What is a 1099 employee?

A 1099 employee is what the IRS considers an independent contractor. The term “1099” comes from the 1099 tax form companies must provide to independent contractors, also known as self-employed workers, freelancers, or gig workers.

An independent contractor is a self-employed individual, or a separate business entity, contracted to provide services to another company. They can negotiate their contract terms, determine their work schedules, and have more flexibility in how they complete their tasks.

There are different 1099 forms that report various types of income and how they were earned, such as through interest, non-employee compensation, or retirement plan distributions. One of the most popular 1099 forms is the 1099-NEC for Non-Employee Compensation payments, which one would expect to receive as an independent contractor. 5 

Independent Contractor 1099: Taxes and Benefits

Independent contractor 1099 employees are responsible for paying their taxes. They receive their full payment without any tax withholding, and it is their responsibility to make quarterly estimated tax payments to the IRS to cover their income tax liability, self-employment tax, and other applicable taxes. They also do not typically receive any benefits from the employer.

As 1099 employees, independent contractors are not subject to the same legal protections as W2 employees and are generally not covered by labor laws. For example, the FLSA states that employers are not required to pay an independent contractor either the minimum wage or overtime pay. 6 

Independent contractors are also responsible for their own insurance and assume liability for their work. In fact, some companies may require independent contractors to hold certain liability insurance policies to perform work on their premises or to gain access to their computer systems.

Avoid using the term ‘contract employee’

Some employers prefer to use the term ‘contract employee’ when referring to an independent contractor, but that can lead to complications. For example, if an auditor comes across that term during an audit, they may dig into the Common Law Test (more on that below) to determine whether the worker is, in fact, an employee or an independent contractor.

Human Resources professional, Leah Babbitt, is an Associate Vice President at the Cameron Group and has over twenty years of HR experience. Babbitt has seen firsthand how the term ‘contract employee’ can complicate an audit. “The fact a business uses the term ‘employee’ may signify employer intent,” said Babbitt.

Babbitt’s recommendation: refrain from using the term. “Businesses and leaders need to be very clear that there are ‘employees’ and there are ‘independent contractors.”

What is the Common Law Test?

The Common Law Test is a set of guidelines used by the IRS and other federal agencies that classify workers as employees or independent contractors. The test measures how much behavioral and financial control an employer has over an individual and the type of relationship both parties share. A worker who meets the guidelines of the Common Law Test is considered to be an “employee.”7 

Common Law Test: Behavioral Control

Behavioral control refers to facts that show whether there is a right to direct or control how the worker does the work. A worker is an employee when the business has the right to direct and control the worker. Some things to consider:8 

  • Degree of Instruction: Degree of Instruction means that the more detailed the instructions, the more control the business exercises over the worker. More detailed instructions indicate that the worker is an employee. Less detailed instructions reflect less control, indicating that the worker is more likely an independent contractor.
  • Evaluation system: If an evaluation system measures how the work is performed, these factors would point to an employee. If the evaluation system measures just the end result, then this can point to either an independent contractor or an employee.
  • Training: If the business provides the worker with training on how to do the job, this indicates that the business wants the job done in a particular way and is strong evidence that the worker is an employee.

Common Law Test: Financial Control

Financial control refers to facts that show whether or not the business has the right to control the economic aspects of the worker’s job. Some things to consider:9 

  • Unreimbursed expenses: Ordinarily, employees are reimbursed for any out-of-pocket business expenses they might incur from their employer. However, independent contractors are rarely reimbursed for tools or supplies unless the contract says otherwise.
  • Method of payment: An employee is generally guaranteed a regular wage amount for an hourly, weekly, or other period of time. This usually indicates that a worker is an employee, even when the wage or salary is supplemented by a commission. An independent contractor is usually paid a flat fee for the job.

Common Law Test: Type of Relationship

Type of relationship refers to facts that show how the worker and business perceive their relationship with each other. Some things to consider:10 

  • Written contracts: Although a contract may state that the worker is an employee or an independent contractor, more is needed to determine the worker’s status. The IRS is not required to follow a contract stating that the worker is an independent contractor responsible for paying their own self-employment tax. How the parties work together determines whether the worker is an employee or an independent contractor.
  • Employee benefits: Employee benefits can include things like insurance, pension plans, paid vacation, sick days, and disability insurance. Businesses generally do not grant these benefits to independent contractors. However, the lack of these types of benefits does not necessarily mean the worker is an independent contractor.
  • Permanency of the relationship: Suppose you hire a worker expecting the relationship to continue indefinitely rather than for a specific project or period. In that case, this is generally considered evidence that the intent was to create an employer-employee relationship.

W2 Employee vs 1099 Independent Contractor

No set number of factors “makes” the worker an employee or an independent contractor, and no one factor stands alone in making this determination. The key is to evaluate the entire relationship and consider the extent of the employer’s right to direct and control the worker.

If you are still unsure whether a worker is an employee or an independent contractor, you can fill out and submit Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding with the IRS. The IRS will review the facts and circumstances and officially determine the worker’s status. However, it can take at least six months to get a determination.11

It is essential for employers to thoroughly understand the differences between W2 employees and independent contractor 1099 employees to make sure they are following federal rules and regulations. The Department of Labor regularly audits companies for compliance and an aggrieved contractor can file a lawsuit, including one seeking class-action status.12

Sources:

  1. https://legal.thomsonreuters.com/en/insights/articles/independent-contractor-vs-employee-what-does-it-matter
  2. https://www.irs.gov/businesses/small-businesses-self-employed/independent-contractor-self-employed-or-employee
  3. https://www.irs.gov/businesses/small-businesses-self-employed/independent-contractor-self-employed-or-employee
  4. https://www.federalregister.gov/documents/2021/01/07/2020-29274/independent-contractor-status-under-the-fair-labor-standards-act
  5. https://turbotax.intuit.com/tax-tips/irs-tax-forms/what-is-an-irs-1099-form/L3NxSPMUe 
  6. https://www.federalregister.gov/documents/2021/01/07/2020-29274/independent-contractor-status-under-the-fair-labor-standards-act
  7. https://www.irs.gov/businesses/small-businesses-self-employed/independent-contractor-self-employed-or-employee 
  8. https://www.irs.gov/businesses/small-businesses-self-employed/behavioral-control
  9. https://www.irs.gov/businesses/small-businesses-self-employed/financial-control
  10. https://www.irs.gov/businesses/small-businesses-self-employed/type-of-relationship
  11. https://www.irs.gov/businesses/small-businesses-self-employed/independent-contractor-self-employed-or-employee
  12. https://legal.thomsonreuters.com/en/insights/articles/independent-contractor-vs-employee-what-does-it-matter