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Employee vs. Contractor: What’s the Difference?

Cynthia Franklin   |    August 16, 2021

There are two ways to categorize your workers: W2 or 1099. What’s the difference?

If you are a growing business, one of the most exciting milestones you can reach is hiring your first employee or contractor. You can finally free up some of your time to work on growing the business or finding new customers. 

But hiring and paying workers comes with a new set of questions, such as… Should I classify my new worker as a 1099 contractor or W2 employee? Am I required to pay benefits? Am I required to keep track of hours?

Additionally, wages are almost always the #1 largest expense for a small business owner – so if your workers do not contribute to additional sales, your profit margin may suffer. 

Here is a breakdown of the difference between W2 and 1099 employment types. 

W2 Employees

A W2 employee is a worker with a distinct advantage. They receive half of their FICA tax (Social Security and Medicare) paid for by their employer. So you’ll be on the hook for those, along with additional taxes such as state and Federal unemployment tax.

As a trade off, the W2 employee works on the schedule that you implement, and does not have control over the work they will perform. This allows you as the employer to have greater control over your workers duties and timeframes. It also allows you to enforce a non-compete agreement with your employees and protect trade secrets. 

Hiring W2 employee is an entailed process. First, if you have never hired employees before, you will need to register as an employer in the state where your employee works, including:

  • Withholding Tax Registration (If your state or locality enacts income tax)
  • State Unemployment Tax Registration
  • Federal Employer Tax Registration 
  • Other State taxes, such as disability or transit taxes, often included with your withholding registration
  • If you plan to provide benefits, you’ll need to identify a plan administrator for health insurance and retirement 
 
Once you have identified your ideal candidate and made an offer, you’ll need to collect an i9, W4, and state withholding election form (and direct deposit information) from your employee.
 
Then, you’ll pay your employees on an agreed-upon schedule. Every quarter, you will file quarterly payroll tax returns. At the end of the year, you’ll file annual payroll tax returns, and issue W2s to each employee that performed any work for you during the calendar year. 

1099 Contractors

In contrast to hiring W2 employees, some business owners choose to hire workers as independent contractors. Instead of paying for half of the FICA tax, contractors will pay their own taxes in full. The employer will not be required to pay unemployment taxes or register as an employer. They also do not withhold income taxes from workers’ paychecks, so the independent contractor must estimate and pay their own income taxes quarterly. 

The IRS stipulates that 1099 contractors must:

  • Control their own schedule and are not held to fixed hours
  • Control the scope and nature of the work they perform (not the business owner)
  • Be hired with existing skills in their field (and NOT rely on training provided by the business owner)
  • Work Part-time for the employer
  • Provide their own tools and equipment
  • Work for multiple clients (or have the ability to do so)
  • May hire their own employees or assistants
  • Typically work on a per-project, rather than ongoing basis
 
At the end of the year, you’ll issue a 1099 to any contractor paid more than $600 during the calendar year for services. 

Categorizing W2 employees as independent contractors to avoid paying FICA or unemployment taxes may result in penalties and re-assessment by the IRS. Be sure that if you utilize workers, you classify and pay them correctly. 

If you are a one-person company, it may benefit you to use 1099 labor instead of W2 employees in order to qualify for a Solo 401(k). Just be sure to follow the above requirements. 

How We Can Help

We can help you keep track of payments to employees, vendors, and contractors. We can also provide referrals for payroll specialists and benefits administrators. Book a free discovery call today to learn more.