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Let’s be honest. Trying to figure out the difference between independent contractors and employees and when to use 1099s and W-2s can be confusing and overwhelming.
But it’s important that you have a basic understanding of how to classify workers, even if you have a payroll service or an accountant to do the heavy lifting when paying them. Whether your workers are employees or independent contractors affects how both you and they are taxed.
For example, you must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to an employee. You don’t usually have to withhold or pay taxes on payments to an independent contractor.
During the hiring process, you can’t decide whether to hire employees or contractors until you understand the difference between the two and why one might be better for your business — or for a specific role you want to fill — than the other. Here’s what you need to know about W-2 employees and 1099 contractors and how they differ.
What are independent contractors and employees?
An independent contractor is self-employed. You enter into a contract with an independent contractor to perform a specific role or complete a specific task. Contractors likely set their own hours and use their own tools. They may even work for more than one business. Since they are self-employed, you do not withhold taxes from their paychecks; they pay their own taxes and provide their own benefits.
An employee is hired by your business under an employment agreement. You withhold taxes from their wages, train them, pay employment taxes for them, and may provide benefits. Because of this, you have more control over your employees — you dictate how and when they work.
How do 1099s and W-2s play into this?
1099s and W-2s are IRS tax forms. A 1099-MISC reports payments made to independent contractors (who cover their own employment taxes, including Social Security and Medicare and their income tax). A W-2 form, on the other hand, is used for employees (whose employer withholds payroll taxes from their earnings).
We know you have more questions, so let’s dive in a little deeper.
What is a 1099 employee?
A 1099 employee is a contractor rather than a full-time employee. These employees may also be referred to as freelancers, self-employed workers, or independent contractors. If you are a business that has 1099 employees, determine what type of work this individual will do for your business. This will help determine what you, as the business owner, could be responsible for as far as reimbursement to benefits.
How to pay 1099 employees
If you use Square Payroll, you can pay 1099 employees by logging into the Payroll section of your online Square Dashboard or Square Payroll app and clicking Pay Contractors. From there you can record a payment that’s already been made or pay by check. While commission-based pay isn’t exclusive to 1099 employees, you may want to track commissions. You can do so by automatically importing them through Square Payroll, a third-party timecard application, or manually entering them. Square Payroll will file Form 1099-NEC online for you.
Benefits of 1099 employees
Contractors, or 1099 employees, are not typically entitled to the standard benefits of full-time employees; however, you can still offer benefits as an employer. For example, in addition to your W-2 employees, your 1099 workers could help qualify your business for a small business health insurance policy. Consider benefits such as retirement plans, discounts, educational resources, or health, dental, and vision insurance as possible benefits for 1099 employees.
Here are a few resources to consider:
- New Gallup Poll Says These Are the Top Employee Perks and Benefits
- 15 Low-Cost Employee Perks Small Businesses Can Offer
- Why Employee Benefits Are Important and How To Offer Them
- 6 Financial Benefits to Consider Offering Employees Now
Determining who is an independent contractor
The difference between an employee and an independent contractor is the degree of control you have over the worker or the amount of independence they have. Pretty vague, we know.
The Internal Revenue Service (IRS) looks at three categories to determine the degree of control or independence in your relationship with your worker:
- Behavioral: Do you control (or have the right to control) what the worker does and how they do their job?
- Financial: Are the business aspects of the worker’s job controlled by the payer (these include things like how the worker is paid, whether expenses are reimbursed, and who provides supplies)?
- Type of relationship: Are there written contracts or employee-type benefits (i.e., insurance, vacation, 401(k), etc.)? Is the relationship permanent? Is the work that is performed a key aspect of the business?
The Internal Revenue Service notes that there is no magic formula that makes someone an employee or a contractor. Instead, it wants you to look at the entire relationship and consider the degree to which you direct that person in their work. But keep in mind that states also classify workers using different factors, and a contractor in one state may be an employee in another, which has downstream impacts on state taxes and state penalties for misclassification.
Because of the complex web of state law and IRS guidance, it’s best to work with tax and legal professionals before making a deciding how to classify.
Once you’ve decided whether the person is an employee or a contractor, make sure you document the factors that led you to that determination.
Independent contractor misclassification
It’s very important to make sure that you are classifying your workers correctly since misclassification can result in costly financial penalties and lawsuits (and no one wants unexpected costs!).
Employee misclassification happens when workers are mislabeled as independent contractors rather than employees. If you misclassify employees, you aren’t paying unemployment and other taxes on your workers when you really should be. And you aren’t covering them with workers’ comp and unemployment insurance when you should be.
If you are found to have misclassified employees as independent contractors, you will likely have to repay all of those taxes and benefits that you weren’t paying before. Common financial penalties include:
- Reimbursement for wages you should have paid an employee, like overtime and minimum wage
- Back taxes and penalties for federal income taxes and state income taxes, Social Security, Medicare, and unemployment
- Payment for misclassified employees’ workers’ compensation benefits
- Providing employee benefits, including health insurance, retirement plans, etc.
What is the difference between 1099 employees and W-2 employees
More and more small businesses are spending money on contractors. In 2020, 6.9% of U.S. sole proprietorship business expenses were spent on contractors, according to the IRS.
Independent contractors have some easy-to-identify benefits for the bottom line. Because you aren’t paying employment taxes and providing benefits for them, contractors can often cost less than full-time employees.
But with the pros, like lower cost, come cons, like the lack of control you might have over your contractor’s schedule.
Here’s a breakdown of some of the pros and cons for both independent contractors and employees.
| Benefits of hiring independent contractors | Challenges of hiring independent contractors |
|---|---|
| Expertise: Contractors work independently. They can focus on a specific project you may not have expertise in. You may consider a contractor for work you need done once or a few times rather than consistently throughout the year. | Less control: Businesses have less control over independent contractors, who tend to enjoy a greater amount of autonomy. Plus, they generally only work for a business for a short time, which can be disruptive. |
| Expenses: Contractors are not classified as employees, so you don’t have to withhold payroll taxes from their payments, and you don’t have to offer benefits like health insurance. (Payments to international contractors may be subject to separate withholding taxes.) This can save money (although not always since some contractors get paid a higher rate). | Legal considerations: Everything about the terms with your independent contractors is covered in your contract. So, draft your contract carefully and get a legal professional to review it. If your working relationship with a contractor comes to an end unexpectedly, be sure to check your contract for any possible breaches. |
| Flexibility and independence: Independent contractors are hired for a specific project or set amount of time, which gives businesses more flexibility in hiring and dismissing them. | Insurance: Employees are covered by workers’ compensation insurance in case of work-related injuries. However, contractors injured on the job do not have the same coverage. Many businesses, including independent contractors, have general liability insurance, so look into what options you and the contractor might have if insurance is needed. |
| Benefits of hiring employees | Challenges of hiring employees |
|---|---|
| Company loyalty: Employees often identify strongly with their job, value the financial security, and may want to stay with the company longer than independent contractors who jump from gig to gig. | Higher expense: You’re not only responsible for employees’ wages, you also have to pay your share of their Social Security and Medicare taxes. You may also need to provide employee benefits like health insurance and paid sick leave. |
| Ongoing support: During busy periods, you can count on your employees to pitch in, work late, and help get the job done. Employees can wear multiple hats and help out where they’re most needed. | Resources: You need to supply your employees with everything they need to do their jobs (unlike contractors). Employees are generally based on-site , so you need to ensure is sufficient workspace for everyone. |
| Greater control: Employers have control over their employees’ schedules, deciding when and how they work. If you need something done a certain way at a certain time, it makes sense to hire an employee to do the job. | Managing employees: When you hire employees, you are responsible for everything from schedules, benefits, and wages to training and management. You are commiting to actively manage how the employee works with you, the business, and the broader team. |
Benefits of W-2s versus 1099s: What’s the difference?
Once you’ve decided whether to hire employees or contractors — or both — you need to get familiar with the forms the IRS requires you to submit for each type of worker. The forms you hear about most are the W-2 and Form 1099.
What is a W-2 form?
If you are hiring an employee, you need a W-2 tax form. A W-2 is a tax form where businesses report an employee’s annual wages, including any miscellaneous income such as tips, payroll taxes, and income tax withheld from that compensation. Employees who receive a W-2 are paid through their employer’s payroll and have their payroll taxes withheld throughout the year.
Employers must mail W-2 forms to their employees by January 31 of the following calendar year. The W-2 form is available on the IRS website. Business owners can also generate and file W-2s through Square Payroll.
1099 versus W-2 tax rates
Having a full-time employee or a contracted employee could result in different tax obligations for business owners. Business owners with W-2 employees must withhold part of Social Security and Medicare taxes from employees’ wages. They are also responsible for paying a matching amount. Typically employer payroll taxes are made up of federal unemployment taxes, state unemployment taxes, Social Security taxes, and Medicare taxes. Business owners generally do not have to withhold or pay any taxes on payments to independent contractors.
Form 1099 versus W-2 Form
If you are hiring an independent contractor, you need a Form 1099. A Form 1099 is a series of documents businesses use to report payments made to an independent contractor during the past year.
An individual or business that pays an independent contractor $600 or more in a calendar year is responsible for sending the contractor a completed 1099-MISC (Copy B) by January 31 of the following calendar year. There are exemptions that exclude some independent contractors from needing to be reported (i.e., if the recipient was a corporation).
The individual or business that sends a contractor a 1099-MISC (Copy B) is also responsible for filing the 1099-MISC (Copy A) with the Internal Revenue Service by January 31 of the following calendar year. You can order free hard-copy 1099-MISC forms from the IRS. Business owners can also generate and file 1099-MISC forms through Square Payroll.
Once you’ve filled out all your 1099-MISC forms, you need to complete Form 1096 with a summary of all the 1099s you prepared and send this to the IRS by January 31. If you file 1099s electronically, you don’t need to file a 1096.
W-2s and 1099s are just some of the tax forms you need to use when you hire employees and contractors. For information on the other forms, consult the IRS website or your accountant.
Managing your workers with Square Payroll
When you decide to hire people, one of the first things you do is set up systems to manage how to pay them. Whether you have only employees (W-2), only independent contractors (1099), or a mix of the two, Square Payroll can make processing payroll easy.
Square Payroll simplifies your operations and helps you save time with fully integrated timecards, workers’ comp, sick leave, and PTO for your employees. It also lets you pay both employees and contractors with direct deposit, takes care of payroll tax calculations (for W-2 employees), and creates your W-2s and 1099-MISCs.
FAQ: 1099 versus W-2 tax rate, pros and cons, and more
Are contractors employees?
A contractor is not an employee. Generally, you have more control over the work that an employee does than you do with a contractor. You must withhold federal income taxes and state income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to employees. You do not usually withhold taxes for a contractor or pay toward other benefits. Instead, they report their taxable income to the IRS.
What is the pay difference between an employee and an independent contractor?
It depends on what you are hiring an independent contractor to do. In some cases, independent contractors are paid more per hour because of their expertise (and that’s what you’re hiring them for).
However, you don’t have to pay for benefits or Social Security, Medicare, or unemployment taxes when you hire a contractor. Because of that, many businesses find independent contractors to be more cost-efficient.
Be aware, though, that misclassification of contractors comes with stiff penalties, so make sure your contractors are classified correctly.
How do you go from employee to independent contractor or vice versa?
If you want to transition your contractor to a full-time employee, hire them for an open position. Using a service like Square Payroll, you can easily transition your contractor to an employee and start withholding and paying employment taxes.
It’s trickier to turn an employee into a contractor. Since workers are assumed to be employees unless proven otherwise, switching from a W-2 to a 1099 may trigger some questions from the IRS. Make sure you talk with your lawyer and accountant before making these changes.
What is the independent contractor tax rate?
Independent contractors pay a self-employment tax because the businesses they work for don’t withhold Social Security or Medicare taxes for them. The self-employment tax rate (made up of Social Security and Medicare taxes) is 15.3%. It’s a little more complicated than that, though (surprise!). Income up to $118,500 is subject to Social Security tax, and all their income is subject to Medicare taxes.
