1099 vs. W2 Employees: Avoid IRS Trouble With Our Classification Tips!

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Hi, I'm Priyanka Prakash, Senior Staff Writer at Fundera.

The difference between 1099 vs. W2 workers is something that trips up a lot of small

business owners.

Unfortunately, if you don't understand the difference between these two types of workers,

it could really cost your small business both legally and financially.

We created this video to explain the difference between 1099 vs. W2 and help you keep your

business in the clear.

Okay, for starters, why should you even care about these acronyms, 1099 and W2?

Well, these are two different kinds of workers that could be part of your team, and the numbers

refer to the different tax forms that you have to send to these workers.

A W2 employee is a regular staff employee who's entitled to minimum wage, overtime protections,

retirement contributions, and other employee benefits.

By January 31 of each year, you'll need to send your W2 employees a W2 form, which shows

their annual wages, and they'll then use that form to file their taxes.

The W2 form will also show any deductions that you made from that employee’s paychecks

throughout the year.

A 1099 worker is not an employee; they're an independent contractor.

You're not required to pay an independent contractor minimum wage or offer them any

kinds of employee benefits.

By January 31 of each year, you'll need to provide your 1099 independent contractors

with a 1099 form, which they'll then use to file their taxes.

So, which is less expensive for businesses: a 1099 contractor or a W2 employee?

Businesses often hire 1099 independent contractors because they're far less expensive for your


There's a long list of things that independent contractors are not eligible for, including

minimum wage, health insurance, disability benefits, unemployment insurance, workers

compensation, sick days, vacation time, and the list goes on.

Plus, employers don't have to deduct or pay payroll taxes on 1099 workers.

When you add up all these costs, you could save about 30% by hiring a 1099 independent

contractor vs a W2 employee.

But, how do you know whether to hire a 1099 contractor or a W2 employee?

And how do you know how to classify your workers?

Once you've hired enough employees, classification is something that you can tell just from the


However, if you're on your first few employees, it’s harder to tell the difference between

a 1099 vs W2.

Here are three questions to ask yourself when figuring out how to classify your workers.

The first question has to do with control.

Do you have control over what the worker does and how the worker does their job?

For example, let's say you hire Lila to design a website for your business.

If you tell her exactly what computer to use, what web builder to use, and what hours to

work each day to get the job done, it's pretty fair to say that Lila is a W2 employee.

On the other hand, if you simply give Lila an overall vision for your website, and let

her implement that however she prefers and on our own time, you have a better case that

she is a 1099 independent contractor.

The second question to ask has to do with financial aspects of the job.

Do you control the business and financial aspects of the worker’s job?

For example, let's say you hire Bradley to provide marketing help for your business.

You provide him with a desk, a computer, and you tell him that you'll reimburse him later

for his cab ride to a local marketing conference that you'd like him to attend.

Since you're providing Bradley the tools that he needs to do his job and controlling how

he'll be paid, Bradley seems an awful lot like a W2 employee.

On the other hand, most independent contractors work offsite on their own time, and they don't

have required obligations on behalf of the company, such as attending a conference.

And the last question to ask yourself is sort of a catch all question that reflects on the

type of professional relationship.

Does the worker receive employee-type benefits, and is the work performed central to the business

to success.

Assume you hire Judy to clean your office every weeknight for an indefinite period of


She brings her own cleaning supplies, but she also checks in with you when she needs

to take time off or take sick days, and you give her some extra pay each month to help

provide health insurance.

This looks very much like a W2 employee relationship.

Independent contractors don't receive employee benefits and usually perform one-off or temporary

services for business.

After considering each of these factors, if you're still confused about a worker’s status,

your best option is to file Form SS-8 with the IRS.

If you file this form, IRS Lawyers will actually look at the specific details of your business's

situation and tell you whether your worker is a W2 or a 1099 independent contractor.

Just be aware that getting back a decision from the IRS can take up to six months, which

could delay your hiring plans.

So, what if you accidentally call a W2 employee a 1099 contractor?

Seems like an innocent mistake, but you might end up paying in big price.

An estimated 3.4 million people are misclassified each year as independent contractors when

they're actually W2 employees.

As you might guess, the IRS does not look kindly on these kinds of misclassifications.

Here are the fines and penalties you're looking at for misclassification.

The first is fines and back taxes from the IRS, including a $50 fee for each W2 form

that was not filed, 1.5% of the employee’s wages, 40% of the employee’s FICA (social

security and medicare) taxes, and 100% of the employer’s matching FICA taxes.

You also have to pay a “failure to pay taxes” penalty, which is equal to 0.5% of the unpaid

tax liability for each month that you misclassified the worker, up to 25% of the total tax liability.

The second problem you're looking at is back benefits.

The worker can claim health insurance, overtime, retirement contributions, and anything else

that an employee would have been entitled to during the period of misclassification.

The final problem has to do with reputational issues.

A lawsuit from an employee can result in poor publicity.

In extreme cases, if the IRS suspects fraud, criminal penalties are possible.

The IRS might also choose to audit your business.

Of course, none of this is meant to scare you, but it should serve as a reminder not

to take any shortcuts when classifying your workers, and if there's any doubt, don't forget

to file Form SS-8 with the IRS, and they'll help you out in determining your worker’s


So, who should you hire ultimately: 1099 independent contractors or W2 employees?

Well, this depends very much on the type of work that you'd like the person to do.

Someone who's doing regular, ongoing work that's central to your company's success is

typically a W2 employee.

This is especially true if you set their hours, provide the tools they need to do their job,

and control their working conditions.

For example, if you own a restaurant, sorry!

Your waiters and cooks are W2 employees, not 1099 independent contractors.

Someone who's truly an independent contractor is their own small business owner.

They can complete a project for you, but they'll set many of the terms themselves.

Hiring a 1099 independent contractor is a good option for one-off projects like website

design, bug fixes, or your annual tax preparation.

Okay, everyone.

That's it for 1099 vs. W2 workers.

Now, all you have to do is go out and hire a great team for your business.

For more information on hiring and other small business insights, head over to funder.com/blog,

and subscribe to our YouTube channel for more videos.

Thanks for watching, everyone.