It’s no secret the modern economy has changed the nature of the working relationship between workers and companies. Many firms have responded to cost pressures by changing how they hire labor in an effort to reduce staffing expenses and control costs.
As a result, many companies now hire independent contractors with strong personal brands for specific, discrete tasks and projects instead of finding more expensive full-time employees. Without knowing about this labor market change, distinguishing between contractors and employees can pose a challenge.
To understand the nuances between employees and contractors from a tax (e.g., 1099 vs W-2, payroll taxes, etc.) and cost perspective (i.e., compensation and benefits paid), as well as other important differences (e.g., company control), this post will walk through the differences between these two working relationships.
What is a Form W-2?
A Form W-2 reports an employee’s year-end amount of compensation paid, taxes withheld, and requisite pay information needed to file federal and state tax returns. The form includes a host of information including payroll taxes withheld, pre-tax benefits (e.g., 401k contributions, HSA contributions), etc.
An employer must submit this form to the IRS and provide copies for the employee to complete a tax return.
What is a Form 1099?
A Form 1099 comes in many flavors. For the purposes of this post, it will serve as a record that an entity or person, not your employer, paid you money. The law requires any payment for services in excess of $600 to submit a Form 1099 to you and the IRS.
Freelancers, independent contractors, or other gig economy workers receive Form 1099s from their clients. These documents reflect the money the client has paid to the worker.
The forms include your Social Security number or taxpayer identification number on it, meaning the IRS will have knowledge of you receiving the money. It will expect you to report this income on your annual tax return.
However, simply receiving a Form 1099 does not indicate you will owe taxes if you take advantage of tax savings opportunities. If you’re looking for other tax avoidance opportunities, learn how to pay zero tax on passive income.
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1099 vs W-2: What’s the Difference in Terms of Taxes?
Because of changing workplace needs, many people must work in a more independent capacity and hold down multiple jobs or lines of work to get ahead. Some do this by choice because it gives them freedom to pursue what they want most while also providing flexibility in their day-to-day lives.
These qualities are synonymous with achieving financial independence and can be an added benefit.
On the other hand, others work as independent contractors to get by until they can find more permanent employment with better pay and benefits. Until such a time comes, working as an independent contractor can be a suitable alternative.
When it comes to breaking down the differences between 1099 contractors and W-2 employees from a tax perspective, the two receive separate tax forms. Independent contractors receive a Form 1099 while employees receive a Form W-2.
As a contractor, Form 1099 shows your total compensation received by this company but holds you responsible for calculating and paying your own payroll and income taxes on a quarterly basis. As an employee, the employer withholds these payroll and income taxes on your behalf and remits them directly to the government.
When it comes to payroll taxes, an independent contractor, you pay not only the worker portion (6.2% for Social Security and 1.45% for Medicare) but the company share as well. Because you are considered the employer when working as an independent contractor, this results in a total 15.3% paid on your earnings in payroll taxes.
However, you can claim a self-employment tax deduction on one half of those taxes, thereby lowering the tax burden. While this still leaves you in the hole compared to an employee who only pays half, one benefit enjoyed by independent contractors, especially after tax reform in 2018, is the ability to deduct expenses related to their work.
The laptop, desk and chair you just bought for your home office? Check, check, check and check (you can even deduct expenses related to having a home office!). All deductible. Employees no longer have the same luxury.
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Classifying Workers Correctly
Making mistakes regarding worker classification can result in costly financial penalties from the IRS. Employee misclassification occurs when companies mislabel employees as independent contractors.
As we’ve already learned, when labeling someone as an independent contractor, the firm does not need to withhold taxes, pay for unemployment insurance, or extend benefits to this worker. When this misclassification occurs, common financial penalties include:
- Reimbursement for wages the company should have paid the employee such as overtime and minimum wage
- Back taxes and penalties for federal and state income taxes, payroll taxes, and unemployment insurance
- Payment for misclassified employees’ workers’ compensation benefits
- Retroactive costs related to providing employee benefits, such as those listed above
Companies should make sure they classify workers correctly at the outset if they hope to avoid these punitive penalties.
Pros and Cons of Hiring Employees vs. Independent Contractors
Major differences exist to an employer based on hiring W-2 vs. 1099 workers. Find a breakdown below of the pros and cons of hiring employees vs. independent contractors.
|Pros of Hiring Employees||Cons of Hiring Employees|
|Greater control: When a company hires an employee, the company can exert greater control over the actions taken by the employee, whether that includes setting schedules, work requirements, assignments, or any other specified task.||Employee management: On the flip side, this also requires layers of management to exercise control and direction over employees. This includes training, managing, and motivating employees to accomplish assigned tasks.|
|Work beyond job description: When workloads increase, having an employee to handle the excess can help. Because employees can handle multiple tasks assigned to them due to the greater control, they can help out beyond items listed in the job description or baseline workload.||Resources: As a downside, this also requires additional supplies, materials, and resources. Because employees often work on-site, providing them with a suitable workspace also increases the cost of hiring and retaining an employee.|
|Career progression and loyalty: Because employees often identify with their role, they will assist the company to achieve its intended pursuit. They have loyalty to the company and not to another client willing to pay more.||Higher cost: Stated above, employees receive consistent pay and benefits, which add to the cost of labor. This includes payroll taxes (Medicare and Social Security), unemployment insurance, health insurance, and anything else a company would need to offer to entice employees to choose them over another company.|
|Pros of Hiring Independent Contractors||Cons of Hiring Independent Contractors|
|Flexibility and independence: Because independent contractors serve for specific tasks and assignments, businesses have greater flexibility hiring and dismissing contractors in the grand scheme of things. If a contractor does a poor job, often the company can terminate the contract and find another contractor to complete the task.||Competitive labor market: If a company finds a talented and capable contractor to perform work for it, the company could easily lose this contractor to a competitor. Because contractors work on assignment, they often seek the highest bid, or certainly the most preferential to their needs. This could include working for a competitor.|
|Lower expenses: Contractors come with lower overall expenses due to no benefits offered as part of the work assignment. Also, because these contracts have no going concern, the labor expenses will eventually discontinue when the assignment has finished.||Legal considerations: All terms agreed to with the independent contractor are found in the contract. Be sure to draft these agreements carefully to address all elements of the assigned work as well as compensation. Also, while some states allow employees to be dismissed at will, independent contractors may have clauses which prevent them from being dismissed or risk the chance of being found in breach of contract. Finally, be mindful of how if contractors get hurt on a job for you, they may have legal grounds to sue.|
|Work expertise: Typically, contractors represent highly-trained individuals in their field of choice. They have accumulated their training and experience from outside means and can often handle tasks with little direction. You may only need this expertise for one task and not on an on-going basis, thereby paying more for a short period to avoid paying an employee to learn these skills.||Less control: Finally, independent contractors have their own way of doing things because companies cannot dictate how they perform their work. This grants contractors a greater amount of autonomy and ability to work as they see fit.|
The primary differences between W-2 vs. 1099 workers include varied tax treatment (i.e., payroll taxes and withholding), pay and benefits expenses (e.g., unemployment insurance and health insurance), and the control exercised over the workers.
From a worker’s perspective, the change in business hiring preferences has led to many more workers falling under the independent contractor classification as opposed to full-time employees. To illustrate this trend, independent contractor expenses as a percentage of total expenses for smaller businesses has increased in the past decade (8.1% in 2014 vs. 5.8% in 2007).
There appears to be no sign of abatement in the gig economy and businesses continue to seek specialized contractors to perform distinct tasks. So long as this persists, contractors will not qualify as employees.
Instead, independent contractors:
- receive contract work from companies
- experience different tax treatment with the ability to claim more tax deductions,
- receive a Form 1099 stating their previous year’s pay instead of a Form W-2,
- have different costs and benefits
This development requires contractors to miss out on the many benefits provided by companies to their employees.
Benefits to employees, which include, but are not limited to:
- medical, dental, and vision coverage
- life insurance
- requisite training provided through on-the-job training or reimbursement
- paid time off
- sick time
Hiring an independent contractor can show a company how to save money on multitudes of benefits costs like those listed above. They can also come with higher hourly rates, less control over how they perform work, and experience restricted capacity if they are asked to work elsewhere for another client.
One final downside for companies hiring independent contractors come from not developing in-house expertise for a contracted project. If this task has an on-going nature, it might benefit the company to hire an employee and train them on how to accomplish this task.
There’s no easy answer to the swirling pros and cons of hiring independent contractors vs. employees. With the direction our economy has trended in recent years, there appears to be no stop in the momentum. Knowing the differences between Form 1099 vs. W-2 will only become more necessary as time passes.
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About the Site Author and Blog
In 2018, I was winding down a stint in investor relations and found myself newly equipped with a CPA, added insight on how investors behave in markets, and a load of free time. My job routinely required extended work hours, complex assignments, and tight deadlines. Seeking to maintain my momentum, I wanted to chase something ambitious.
I chose to start this financial independence blog as my next step, recognizing both the challenge and opportunity. I launched the site with encouragement from my wife as a means to lay out our financial independence journey and connect with and help others who share the same goal.
I have not been compensated by any of the companies listed in this post at the time of this writing. Any recommendations made by me are my own. Should you choose to act on them, please see my the disclaimer on my About Young and the Invested page.