1099 vs. W-2: Which Type of Employee Should You Hire?

By
Dock David Treece
,
business.com writer
|
Aug 07, 2020
Image Credit: fizkes / Getty Images

There are pros and cons to hiring both W-2 full-time employees and 1099 contractors. It is important to know what those are before you decide which way to go.

When you're hiring employees, there are two primary types to consider: 1099 independent contractors and full-time W-2 employees. Each type has its own advantages. An independent contractor is often better for specific projects or inconsistent workflow, while full-time W-2 employees are better when you want someone who will work and grow with your company for a long time.

What is the difference between 1099 vs. W-2 employees?

W-2 and 1099 employees are defined by the tax forms that are used to report their incomes. Full-time employees receive IRS Form W-2, which provides details of their wages and earnings for the year. Independent contractors receive Form 1099, which lists their wages, salaries and tips.

1099 workers aren't direct employees of your company – they're independent parties, more like vendors. W-2 employees, on the other hand, are part- or full-time employees of your company. While 1099 contractors have no inherent loyalty to your company and can leave at any time, W-2 employees owe more to their employers, which sometimes includes any work product they developed on company time or with company resources.

In exchange, W-2 employees are eligible for company benefits, including health insurance and a 401(k) retirement plan. 1099 contractors generally aren't eligible for these employee benefits. Instead, 1099 contractors are largely project-based workers or in a trial period when they join a new employer. Company managers and full-time employees with consistently full workloads are more often W-2.

The implications of using W-2 employees vs. 1099 contractors

When deciding whether to structure new hires as W-2 employees or 1099 contractors, you should be aware of the legal implications of both.

For one thing, W-2 employees are meant to be full-time workers for a single employer. You can restrict W-2 employees from working for other employers – especially their competitors. You might also have rights to employee work product that is created or improved on company time or using company resources. This is especially important in high-tech or creative fields like software development.

But there are also financial considerations for employers, including requirements to withhold payroll taxes for W-2 employees and to provide employer-sponsored benefits for all eligible employees.

1099 contractors, on the other hand, are not eligible for company benefits, and their income taxes are not withheld by employers. However, employers have no right to exclusivity of contractors' work, nor can they normally claim any ownership over contractors' inventions or discoveries.

To demonstrate just how important the difference between W-2 and 1099 workers can be, consider the ongoing case against ride-sharing app Uber. Uber classifies all of its drivers as 1099 contractors, but several states have sued the company to require the company to reclassify workers as W-2 employees. This would require Uber to pay drivers a minimum wage and make them eligible for other company-sponsored benefits, as well as payroll tax withholding.

What is a 1099 worker?

1099 workers are independent contractors. They are not technically part of the organizations that employ them; they are separate from their employers and treated more like vendors than employees.

To classify workers as 1099 contractors, employers should be able to demonstrate that they have limited control over the worker. According to the IRS, employers who answer yes to any of the below questions about the type of control over they have over their 1099 contractors may need to classify them as W-2 employees:

  1. Can the employer dictate or control what the employee does or how they do their job?
  2. Does the employer directly control how the worker is paid or whether expenses are reimbursed? Does the employer provide tools and supplies required for the worker to do their job?
  3. Does the employer provide the worker with benefits, such as retirement benefits, health insurance or paid time off? Is the worker's function key to the operation of the business, such as senior management?

Employee misclassification can open your business up to all sorts of liability, including penalties for failing to withhold payroll taxes – not to mention liability from workers who may be denied benefits or a minimum wage.

To onboard a 1099 contractor, you'll need them to complete IRS Form W-9.

What is a W-2 employee?

Unlike 1099 contractors, W-2 employees are full-time workers dedicated to specific employers. In most cases, any employee who is responsible for managing other workers at a company is a W-2 employee.

W-2 employees typically receive salaries as well as benefits (if they're eligible), including health insurance and retirement saving options. Because you must provide benefits to your eligible W-2 employees, they are typically more expensive than 1099 contractors. Managing W-2 employees can also be more involved.

Employers are required to collect certain documents from new W-2 employees when they start. These include Form W-4, because employers have to withhold income taxes from their paychecks. 

Nevertheless, these are some cases where W-2 employees make more sense to hire than 1099 contractors:

  • Your company wants to keep a worker for a long time.
  • Your company wants exclusive rights to the employee's work product.
  • You are hiring the employee to serve in a management capacity.

When to use contractors vs. employees

Many businesses prefer to simplify their hiring by only hiring full-time W-2 employees. Employers often want to exert financial or behavioral control over employees by having them work in an office during set hours each week, for example. But there are certain instances when contractors are better:

  • You are giving a potential hire a trial period.
  • You're hiring employees to work on a particular project for a set period of time.
  • You only need help for a certain amount of time.
  • You don't want to pay for a worker's benefits.
  • Your business is in an industry with high employee turnover.
  • You don't have many employees and payroll tax withholding is too complicated. 

What are 1099 and W-2 tax forms?

The tax forms used to report income for 1099 and W-2 workers are relatively straightforward: Full-time employees get a W-2 form and independent contractors get a 1099 form. Both of these forms are used to report workers' wages and tips, and must be filed by Jan. 31 of each year. Both of these forms are also used by workers to report their personal incomes on their tax returns.

How those taxes are paid is usually a different story. 1099 contractors make their own tax payments. In fact, when companies hire 1099 contractors, the form that reports their wages may not even go to the workers as individuals. In some cases, workers may have their own LLCs or other entities that they use for billing employers. In these cases, 1099s report their company's revenue from the firms that employ them – just like any other vendor.

In the case of W-2 employees, employers are responsible for withholding their income taxes. When employers provide the W-2s each January, the forms go to the employees personally (employers don't send W-2s to companies, only to individuals) and are used to report their personal income and taxes withheld throughout the year.

1099 vs. W-2: Which do workers prefer?

Whether individual workers prefer to be classified as contractors or employees varies by their industry, function, work style, employer and other factors.

Some professionals prefer the flexibility of working for multiple employers or change companies frequently. In these cases, working as a 1099 contractor can be a lot easier. These workers pay for their own health insurance, fund their own retirement accounts and so on.

Other workers like the stability of full-time employment and prefer to get benefits like health insurance from their employer, rather than buying their own. Some are managers, which typically need to be W-2.

Preferences between W-2 and 1099 can also be an issue of lifestyle. For one thing, W-2 employees usually have a much easier time getting financing, as lenders only need to see one or two months of pay stubs, rather than the two or three years of tax returns that 1099 contractors must provide to get a loan.

So, workers with families and large mortgages (or those who want to get a mortgage in the near future) may prefer working as W-2 employees rather than as independent contractors.

1099 vs. W-2 hiring process

There's very little difference in the recruiting process for 1099 contractors and W-2 employees – except that you should make clear from the outset whether you're hiring for a full-time role in your company or a contractor.

Once you've hired an employee, there are some slight differences in employment agreements between the two types of workers. Contractors, for example, typically have a contract that explicitly outlines the terms and duration of employment. W-2 workers also often have employment agreements, but there's usually no set term.

When you hire a 1099 contractor, they need to complete Form W-9 for the information necessary to report their compensation on Form 1099 at the end of each year. W-2 employees need to complete a W-4 to get set up for income tax withholding. They also need to complete paperwork for enrollment in employer-sponsored benefits, such as health insurance, workers' compensation or a 401(k).

The pros and cons of hiring employees or contractors

Contractors

Pros Cons
No benefits Overtime
Streamlined payroll with no withholding No employee loyalty
Simple onboarding No severance

No expectation of raises or promotions

No right to contractor work product

 

Employees

Pros Cons

Exclusive rights to work product

Benefits eligibility
No overtime Income tax withholding
At-will employees (usually) who can be terminated at any time Benefits enrollment included in onboarding
Possible severance in the case of layoffs Employee expectations for raises and advancement
Dock David Treece
Dock David Treece
Dock David Treece is a former investment advisor and member of FINRA's Small Firm Advisory Board. After more than a decade in the financial services industry, he now works to share information about personal and business finance topics so that readers can make informed financial decisions. He has a degree in Finance from the University of Miami and lives in North Carolina.
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