W2 vs. 1099: Everything you need to know (2024)

What is a W2?

A W2 is a tax form issued to employees who earned more than $600 for the year by their employers after the conclusion of every calendar year. It reports the employee’s wages, commissions, tips and other compensation over a 12-month period. It also reports all Medicare, Social Security and income taxes withheld from the employee’s wages throughout the year.

What is a 1099?

1099-MISC

A 1099 form is a form used to report income for nonemployee workers and miscellaneous sources. Typically, income reported on a 1099 has not yet had any taxes withheld, and those taxes are the responsibility of the recipient. In the context of small business usage, there are three primary types of 1099s, including the 1099-MISC, the 1099-NEC and the 1099-K.

1099-MISC

A 1099-MISC must be issued to any nonemployee to whom you paid $600 or more in a single calendar year in miscellaneous payments other than payments for a contractor’s services. The $600 limit can apply to cash compensation or to:

• Rent payments your business made.
• Prizes and awards your business issued.
• Fishing boat proceeds.
• Medical or healthcare payments your business paid to benefit the recipient.
• Crop insurance payments.
• Money your business paid to an attorney.
• Other income payments.
• Consumer products you sold to anyone working on a commission basis if the sale was greater than $5,000.

1099-NEC

You can also report the sale of consumer products over $5,000 on a commission basis on a 1099-NEC. This form, however, differs from the 1099-MISC in that it is used to report nonemployee compensation of over $600. Simply put, it is used to report payments made to contract or freelance workers for services they rendered to a business throughout the year.

Employers first issue a W9 to contractors to gather information such as the contractor’s identity, taxpayer ID number and contact information. Then, in January of the following year, a W9 form is used to fill out a 1099-NEC form to report income to the IRS that was paid to the contractor throughout the year. A copy is also sent to the contractor. Contractors or freelancers then report this income on a schedule C form with their income tax returns.

1099-K

The 1099-K form is used to report payments made using third-party payment networks or online marketplaces. For example, these payments may be made to credit cards, debit cards, gift cards, payment apps or online marketplaces. Payment types include:

• Payments made on peer-to-peer payment platforms or digital wallets.
• Online marketplaces for selling clothing, furniture or other consumer goods.
• Craft marketplaces.
• Auction sites.
• Car sharing or ride-hailing platforms.
• Real estate marketplaces.
• Ticket exchange or resale sites.
• Crowdfunding platforms.
• Freelance marketplaces.

W2 vs. 1099: Employee differences

If you are considering growing your team, you may wonder if you should hire a W2 employee or a 1099 contractor. Riley Adams, CPA and owner of Young and the Invested, says a W2 employee may be a better option if you’re seeking a lot of control over the work product, how the employee uses their time and where they work. You have far less of that control when you work with a 1099 contractor.

The work a contractor does is typically well-defined and project-limited. They’re more likely to get paid per task than paid per hour, but can be paid by the hour depending on industry norms. If you’re hiring someone to stay with the company long-term, you are more likely to hire a W2 employee.

Contractors paid through a 1099 are often less expensive for business owners. The contractor is self-employed, so they have to pay both the employer and employee portion of Federal Income Contributions Act (FICA) taxes, relieving the business of those tax obligations. The business is also not required to withhold income taxes. Contractors aren’t entitled to company benefits, like retirement accounts or group health insurance plans, further reducing employers’ costs.

Real-world examples of 1099 and W2 workers

Adams gives the example of a contractor filling in for someone on maternity leave. When they were taken onto the team, it was established that they’d be in the role for a limited amount of time until the permanent employee returned. In this case they’d be a 1099 worker. But if they stayed on after the permanent employee returned, they may need to be reclassified as a W2 employee.

“After the person intended to be temporarily replaced returns, the employer should probably convert the contractor to an employee,” Adams says.

In another example, a groundskeeper works full time for a bed and breakfast. They’re there everyday and do work regularly at the behest of the B&B owner.

In addition, in the winter, the groundskeeper runs a snow plowing business on the side. They have many clients, and while the B&B is one of them, they only clear the parking lot on an as-needed basis.

Money paid to this individual as a groundskeeper would be reported on a W2, subject to payroll taxes. However, money rendered for the snow plowing services would be reported on a 1099, and none of that income would be subject to withholdings.

Even when you intend to hire a worker as a contractor, if they’re providing the primary service or activity of your business, they are more likely to be classified as an employee. For example, if a law firm signed on a lawyer, it would be more appropriate to treat that attorney as an employee rather than a contractor.

Misclassification of 1099 and W2 Employees

Penalties for misclassification

When you’re making a hire, be sure to classify the worker correctly the first time. The consequences of failing to do so can be severe.

“Misclassifying workers can lead to serious legal repercussions,” says Adams. “For violating such laws, and depending on the severity of noncompliance, the employer can be assessed criminal penalties and back taxes for this misclassification.”

Some other expenses and penalties the business could face include:

• Retroactive payment of Social Security and Medicare taxes.
• Withholdings for local, federal and state income taxes.
• Retroactive contributions to disability, unemployment and workers’ compensation programs.
• Retroactive overtime payments.
• Paying the difference for the time the worker was underpaid as a contractor according to minimum wage laws.
• Retirement contributions and health insurance lost during time misclassified as a contractor.
• Additional state or locally required penalties, which are often governed by three-pronged ABC tests to determine a W2 vs. 1099 status.
• Criminal conviction that could result in fines of up to 42% of the workers’ wages over the last three years and/or jail time.

Recent misclassification cases

Many states argue that corporations take advantage of independent contractors. Perhaps none are so prominent in pop culture as app-based companies in which the corporation relies on independent contractors to perform its services for the customer. An example of one such company that has undergone investigation is Uber.

Uber’s primary business is driving its customer base from point A to point B — a task completed entirely by their fleet of independent contractor drivers and via the Uber app. While some Uber drivers work unpredictable shifts as a side hustle when they can fit it into their schedules, others end up driving as their sole source of income.

When these circ*mstances were put up against New Jersey’s ABC test (a test that determines worker classifications), the state saw reason to file a lawsuit against Uber, resulting in a settlement of $100 million paid in 2022.

“We will not tolerate companies that misclassify their workers, thereby denying employees vital benefits and dodging their obligation to contribute to programs that benefit the workforce,” said Acting New Jersey Attorney General Matt Platkin in September 2022.

“By misclassifying workers, companies both harm their employees and sidestep their obligations under the law. New Jersey will continue to enforce our employee misclassification laws aggressively to prevent such conduct. As the economy changes, we will vigorously defend workers’ rights.”

Uber did not admit fault, though, and continues to operate in New Jersey with independent contractors. There have been similar lawsuits across the nation, including an ongoing case against GrubHub in California. But, thus far, these companies have been largely successful in avoiding any changes to their business models by appealing court rulings or advocating for state and local laws to be passed in their favor.

How to choose between a 1099 or W2 employee

If you’re signing an independent contractor, you will likely have fewer labor expenses than if hiring an employee. At the same time, you’re going to have to relinquish some control. For example, if you have weekly team meetings, you cannot demand that the contractor participate. There are several pros and cons to hiring an independent contractor. Considering these benefits and disadvantages can help you choose the right classification for your business needs.

1099 classification: Pros and cons

Sometimes, an employer/employee relationship may be more beneficial — even if the labor expenses are higher under this arrangement. As Adams was building his small business, he worked primarily with contractors. Recently, he converted one of the contractors into a W2 employee and has been pleased with the results.

“While this employee technically costs me more than when she worked as an independent contractor, the amount of time savings and stress reduction she provides in her role as an employee has far outweighed the costs of hiring her full time,” Adams says.

“Plus, once I’ve trained this employee on our system, the amount of time required to complete each subsequent task is reduced, providing for greater productivity.”

W2 classification: Pros and cons

If you’re working with a 1099 contractor who you’d like to convert into a W2 employee, you can use the Voluntary Classification Settlement Program. This IRS program allows you to pay reduced employment taxes for the current year in exchange for converting your workers into employees. It also prevents you from being audited for any previous misclassification of those employees further down the line.

1099 vs. W2: state laws

States can set more concrete guidelines surrounding 1099 vs. W2 classifications, and none has garnered as much attention as California in recent years. In 2019, the state set its ABC test to define independent contractors as those who could satisfy all three of these requirements:

“(A) The person is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact.

(B) The person performs work that is outside the usual course of the hiring entity’s business.

(C) The person is customarily engaged in an independently established trade, occupation or business of the same nature as that involved in the work performed.”

However, there are seemingly competing laws. California voters passed Proposition 22 in 2020, which established gig drivers as independent contractors in perpetuity — despite the ABC test. It also included limited protections for contractors, such as minimum-wage and maximum work-hour restrictions, both protection types that are often only granted to employees. Under this proposition, workers make at least 120% of the minimum wage and limit working hours to 12 in a 24-hour period, among other protections.

As evidenced by the golden state, laws are nuanced and they can change quickly. It’s important to stay on top of your state and local laws as time goes on, as they can be more restrictive than federal definitions.

Frequently asked questions (FAQs)