The classification and meaning of 1099 freelancers and W2 employees is always prone to confusion in the American corporate sector. In simple words, 1099 workers are independent contractors, and W2 are employees on the company’s payroll; they are named after their respective tax forms. Companies provide 1099-NEC to independent contractors, and employers file W2 on behalf of their employees. Correct classification of a worker is crucial as it affects how both the worker and company are taxed. Misclassification of employees can lead to heavy penalties from the Internal Revenue Service (IRS) and Department of Labor (DOL).

The distinction between 1099 workers and W2 workers affects self-employment taxes,⁠ income tax withholding, unemployment taxes, social security, and Medicare withholdings. It also determines the forms that businesses are required to file.

To save themselves from costly fines and legal fees, companies need to be sure of the type of employee they require at the time of hiring.

 

1099 FREELANCERS

A 1099 worker is an independent contractor who works independently with one or multiple clients. They set their own hours, decide their working location, and use their personal tools for work. They usually work on-demand or on a project basis. Sometimes, 1099 freelancers are business owners and hire their own workers to help them deliver the work to clients. They usually work with the company for a predetermined time period. Freelancers or independent contractors work for a fee mentioned in their written agreement. They are either paid a fixed price for the project or an hourly rate, but cannot partake in any employee benefit programs.

 

W2 EMPLOYEES

W2 workers are full-time or part-time employees on the company’s payroll. The employer has full control over the working environment and can dictate where and how they work. They have the right to participate in employee benefit programs such as health insurance, retirement contributions, and flexible spending accounts. The company hiring them is responsible for withholding their income, social security, and Medicare tax. W2 employees are protected by Federal Labor Law and cannot be paid less than the federal minimum wage. If any rules in respect of payroll compliance rules or HR are broken, employers can face litigation.

The IRS examines three categories to ascertain whether the worker falls in the 1099 or W2 category. The categories are as follows:

1. Behavioral Control: A worker becomes a W2 employee if the employer can control their working hours, location, and tools. Whether they exercise their control or not does not matter. Simply put, if the company is deciding when, where, and how the work is performed, then they have hired a W2 employee.
2. Financial Control: When the business controls the economic aspect of the job, then he becomes a part of the W2 workforce. It includes the method of payment, how the payment is calculated, etc. If the worker is getting a fixed, regular salary, they will likely be categorized as W2.
3. Type of Relationship: The relationship between worker and business is a major deciding factor in classifying the type of employment. To understand the respective relationship, one should go through the contract or employment agreement and read about the length and terms of the said agreement.

 

PROS AND CONS OF 1099 FREELANCER FOR EMPLOYERS

Pros

• Tax Benefits: Employers have a legal obligation to shoulder the tax burden on their employees. But, even if they’re paying higher taxes to a 1099 employee, they are entitled to tax relief measures that ease out their burden.
• No Training Costs: An employer has to bear the burden of training new hires for their jobs. With 1099 employees, the high training and supervision costs are avoidable.
• No Equipment Cost: Typically, employers don’t provide work tools or equipment to contractors– they can save on office space, laptops, computers, festive hampers, and more.
• Flexibility: Just like a 1099 employee, employers also have control over whom to hire, for what skill sets, and what duration. They aren’t obligated to enter into a long-term working relationship with any contractor. Instead, they can hire people with specific skills to meet their business needs for a specific time period.

 

Cons

• No Control: Due to the nature of their relationship, employers have limited control over 1099 employees. Contractors are allowed to leave anytime as most contracts are short-term or at will, making it difficult to retain them for longer periods when needed.
• Less Supervision: The flexible nature of contractors means that employers have less oversight over their work or their progress. This might lead to inevitable delays in work and create opportunities for missed deadlines.
• Low Quality of Work: 1099 employees tend to have multiple clients and/or projects at one time. Employers are at high risk of receiving sub-par work with divided concentration and focus as 1099 employees are seldom invested in an organization’s long-term goals.

 

PROS AND CONS OF W2 FOR EMPLOYERS

Pros

• Company Loyalty: W2 employees are hired after going through an intensive process, and there are high chances of hiring employees who understand, accept, and enhance the company culture.
• Committed Employees: W2 employees are not hired on a per-project basis but for a longer duration. The employees benefit from job security and a steady stream of income, while employers are able to leverage consistent work.
• Control: Employers can exercise more control over W2 employees, where they can dictate the terms of employment, oversee employee training, delegate tasks, and suggest how a particular task needs to be done.

 

Cons

• Employee Burnout: W2 employees face burnout when they work too hard and might not be able to deliver high productivity at work. 1099 employees might not be loyal to your organization, but they are able to generate fresh ideas for new projects each time.
• Training Costs: W2 employees incur high training costs– they have to be provided with the basic skills training, equipment for work, employee benefits, and more, which add up to quite a high cost.

 

 

TAXATION FOR 1099 WORKERS VS. W2 EMPLOYEES

The federal tax obligation for W2 employees falls on the employer, as the company is required to file form W2 for any part-time and full-time employee who receives a minimum of 600$ from the company. W2 is filed with the IRS, Social Security Administration (SSA), and other tax authorities, if applicable. They are required to distribute the filed forms to the employees by January 31st.

The independent contractor that earns more than 600$ receives Form 1099 NEC (non-employee compensation), which shows the basic details like name, address, Social Security number, and total earnings for the year. The due date for filing form 1099 is January 31st. (Internal Revenue Service)

 

THE REPERCUSSION OF MISCLASSIFICATION OF EMPLOYEES

One thing that’s clear is that the way businesses classify their workers is important. But, how does the law determine whether a person is a 1099 employee or a W2 employee?

Though there is no set test to determine the same, the moral of the story is that the more control an organization has over the way a person works, the more likely it is that the person is their employee rather than a contractor.

Misclassifying the employees is a risky business. The Internal Revenue Service and department of labor are very active and conduct regular audits to track down any intentional or unintentional misclassification of employees. The same is dealt with severity by the government. There are two faces of misclassifying employees:

First, IRS Penalties levied by the United States government can be very costly for companies. If the IRS discovers the employee-employer relationship unintentionally misclassified as client-contractor, the company could be subject to:

• A fine of 50$ per misclassified worker
• A penalty of 1.5% of the employee’s wages
• 40% of the FICA taxes that were not withheld and 100% of the matching FICA taxes the employer was supposed to pay. Interest in the penalties is also accrued.

Second, in the case of misclassification with the intent of fraud, the IRS may require companies to pay back 100% of the FICA and income taxes that should have been withheld from the employee. The criminal penalties for deliberate misclassification of employees lead to a maximum of 1000$ for each W2 form that the employer failed to file, and one year in prison can be sentenced. The person responsible for such fraud can be held personally liable for any uncollected taxes.

 

SO, WHAT IS A BETTER FIT FOR YOUR COMPANY: 1099 OR W2?

There is no right or wrong answer.

Deciding between 1099 and W2 is a challenge that every business owner faces. The Independent contractor or freelancer is a strategic decision to economize and save the cost. The full-time employees will create a steady stream of work for your business. Before deciding the exact ratio of 1099 and W2 workers, one should give due consideration to the type of work, budget, availability of tools, and level of control required.

 

Both of these categories have their advantages and disadvantages. So, the experts at McKinley Rice advise relying upon the hybrid approach to grow and scale your business. Hire a mix of both types of employees depending upon your requirement.