IRS Form W-2 vs. 1099-MISC: Understanding the Tax Implications of Employee and Independent Contractor Classifications

When hiring new employees, small businesses must determine whether the new hire is an independent contractor or a full-fledged employee. The difference between the two classifications has major tax implications. Employers are required to file an IRS Form W-2 for employees and an IRS Form 1099-MISC for independent contractors. A worker’s classification hinges on whether the employer has the right to control the work and whether the worker is an employee or an independent contractor. Employers who are unsure about classification can seek help from a CPA or legal advisor. Misclassifying an employee has severe consequences, including lawsuits and hefty penalties.

What’s the difference between a 1099 and W-2?

With every dollar you (and your employees) make, a certain percentage goes not just to the federal government, but to local and state jurisdictions as well. As those taxes are taken out of a person’s pay, whether it’s through automatic tax withholding by the business owner or estimated quarterly payments made by the individual, those funds go toward Social Security, Medicare, and unemployment.

When you hire workers, you must determine their classification – either as an employee within your company or an independent contractor – as you will be required to file either IRS Form W-2 or IRS Form 1099-MISC for them. The difference may not seem paramount, but Mark W. Everson, vice chairman of alliantgroup and former IRS commissioner appointed by President George W. Bush, emphasizes its importance for small businesses in particular.

“The rules concerning employee and independent contractor classifications are complex and frequently debated at both the federal and state levels,” Everson said. “It’s extremely important to understand the legal and tax obligations associated with each classification and how closely they coincide with one another.”

According to the National Conference of State Legislatures, the standard for whether someone is an employee hinges on whether the employer “has the right to control the work, the worker is an employee, not an independent contractor” or the employer can “exercise behavioral and financial control over the worker.”

If you’re hiring someone as a full-fledged employee of the company, you must file a W-2. For each independent contractor under your employ, you must file a 1099.

For employers who are unsure about a classification, Everson said a CPA or legal advisor, whether in-house or hired temporarily, can help with the decision-making process.

Why you would file a W-2

In most instances, you will be filing a W-2 for a new hire. This kind of hire generally means that “small businesses will have greater control over their work and compensation” while remaining a “relatively fixed cost,” Everson said.

With control over the “what, when and how” of an employee’s responsibilities within the company, you are entering into an employment agreement with the new team member. You also assert that you will train the new hire, provide an employee benefits package if you have one, and pledge to withhold taxes from an employee’s paycheck.

According to the IRS, you will have to file a W-2 if you “withheld any federal income tax, Social Security tax or Medicare tax from wages, regardless of the amount of wages,” and if your employees claim more than one allowance.

Why you would file a 1099

If your small business relies on independent contractors to fill certain roles, you should familiarize yourself with the 1099. You do not withhold taxes from what you pay your independent contractors. Instead, you file a 1099-MISC to report to the IRS exactly what you paid to your contractors, otherwise known as “non-employee compensation.”

In most instances, a business must file a Form 1099 if it pays a contractor more than $600 in a calendar year. When the company files the 1099-MISC, Copy A of the form is sent to the IRS, while Copy B goes to the independent contractor by January 31 in the following year. Businesses must also file Form 1096 to outline all the 1099s that it prepared for its independent contractors, if filed by hand.

Hiring a worker as an independent contractor, said Everson, could ultimately work out in favor of the company.

“Hiring independent contractors can be cost-effective in large part because the business will have reduced payroll tax obligations and oftentimes lower benefit costs,” he said.

According to the IRS, a worker’s classification hinges on how much control the business has over them. To help companies determine whether an individual is an employee or an independent contractor, the IRS recommends that employers consider the following questions:

  • Who has control over the worker’s responsibilities and hours?
  • Does the business control the financial aspects of the worker’s job?
  • Has a contract been signed, or does the employee receive benefits?
  • Is there a degree of permanence to the worker’s duties at the company?
  • How important is the employee’s work to the company’s continued operation?

Though the decision of whether to classify a worker as an employee or an independent contractor is up to the employer, there are strict guidelines and repercussions for misclassifying someone.

What happens if an employee is improperly classified?

Since a worker’s classification as an employee or independent contractor has a major impact on how that person handles their taxes, it’s important to get it right. A mischaracterization could result in lawsuits and hefty penalties if the employer is found to be at fault. 

Improperly characterizing a worker as an independent contractor could create major problems for that individual. Under the Fair Labor Standards Act, independent contractors are not protected by many existing labor laws. Employers do not have to provide a minimum wage or overtime to independent contractors, nor do they offer unemployment insurance and workers’ compensation.

If your company is found guilty of independent contractor misclassification, you could be legally compelled to reimburse lost wages like overtime, cover back taxes and penalties at the state and federal level, pay for workers’ compensation/unemployment insurance costs, and provide benefits like health insurance and retirement plans.

How to file W-2 and 1099 forms

Whether you have to file a W-2 or 1099, the process is largely the same, though the information you submit is different.

1. Determine how you want to file your taxes.

If you file taxes electronically, you can use the online software solution you’re comfortable with. Most online tax software will walk you through the process, though there may be some additional costs for using the service.

If you want to file your forms the old-fashioned way, you’ll need to first download and fill out the forms from the IRS’s website or order the requisite forms. Before filling out the forms, you’ll need the completed W-4 forms from your employees and W-9 forms from your contractors.

2. Submit your 1099 forms by the deadline.

After filling out the 1099 form, you will need to submit Copy B and Copy 2 of the 1099 to the independent contractor by January 31, while Copy A goes to the IRS, and Copy 1 goes to your state’s department of taxation. Copy C is kept for your own records.

3. Submit your W-2s by the deadline.

When filing a W-2, the same online options are available to you as a business owner. You can also order the necessary forms online to be delivered to you by the postal service. The IRS requires that the W-2, along with all tax information, be sent to them by January 31 of the next tax year. Documents must also be filed with the Social Security Administration (SSA).

To fill out the W-2 forms, you’ll need identifying information for each employee, including their name, address, Social Security number, and how much income they earned throughout the year, among other things. You will also need your company’s employer identification number and state identification number. Once completed in red ink, Copy A goes to the SSA. You keep Copy D for your own records.

In conclusion

It is crucial for small businesses to correctly determine whether a new hire is an independent contractor or an employee, as it has significant tax implications. Employers are required to file either IRS Form W-2 for employees or IRS Form 1099-MISC for independent contractors. The classification depends on whether the employer has control over the work and whether the worker is an employee or an independent contractor. If an employer is unsure about the classification, it is best to seek help from a CPA or legal advisor. Misclassifying a worker can lead to lawsuits and hefty penalties. Additionally, the decision of whether to classify a worker as an employee or an independent contractor should be made carefully, as there are strict guidelines and repercussions for misclassifying someone.

FAQ

What is the difference between a 1099 and a W-2?

A 1099 is for independent contractors, while a W-2 is for full-fledged employees.

Why is it important to determine worker classification?

Worker classification determines which form to file for taxes and affects the employer’s legal obligations.

What are the legal and tax implications of employee and independent contractor classifications?

The rules are complex and can result in lawsuits and penalties for misclassification.

How is a worker’s classification determined?

A worker’s classification depends on whether the employer controls the work and whether the worker is an employee or an independent contractor.

What are the benefits of hiring full-fledged employees?

Full-fledged employees provide greater control over work, compensation, and employee benefits.

Why is it important to file a W-2 for employees?

The IRS requires a W-2 for employees to report withheld taxes, Social Security tax, and Medicare tax.

Why is it important to file 1099 for independent contractors?

Form 1099 is required for independent contractors to report non-employee compensation to the IRS.

What are the criteria to determine a worker’s classification?

The employer must consider who controls the worker’s responsibilities and hours, financial aspects of the job, contract, benefits, and permanence of the work.

Can hiring independent contractors be cost-effective?

Yes, hiring independent contractors can be cost-effective because it reduces payroll tax and benefit costs.

What are the consequences of misclassifying a worker?

Misclassifying a worker can result in lawsuits and penalties for the employer, as well as problems for the individual worker.