Workers can be classified into two main categories: W-2 employees or 1099 workers. Each classification is unique in terms of job function and taxes. It’s also very important for your business to classify employees correctly to avoid potential IRS audits, lawsuits, and wage claims. Here are the main differences between a W-2 and 1099 worker, and the potential issues that arise if they are misclassified.
A worker is a W-2 employee if they are employed directly by the company, receive regular pay through payroll, and are eligible for benefits offered by the company. W-2 employees can be full-time or part-time, but they work according to the company’s policies and procedures in the employee handbook. With W-2 employees, employers are required to withhold Social Security and Medicare taxes. Employers are also required to deposit federal and state income taxes on these employees, and report unemployment taxes (also federal and state). The company must also report any additional employee income, such as tips, commissions, or other forms of compensation. The company provides all the tools and resources needed for the employee to complete their basic job functions. These employees will receive a Form W-2 from the employer for the time worked during the year.
A 1099 worker is often referred to as an independent contractor or freelancer. A company typically hires this type of worker for a specific project and includes a written contract containing all the terms of the project. The company does not have an obligation or responsibility to supply any resources needed to complete the project, so the 1099 worker would provide what they need themselves. 1099 workers can work for multiple companies (clients) at once, and can hire their own workers to assist with completing the project. As for taxes, when a company contracts a 1099 worker, it is not required to withhold or file any taxes for them. The 1099 worker will record their income for the year, and pay their own taxes on a 1099 form. Company benefits are typically not offered to a 1099 worker as they would a W-2 employee.
How to Determine Which Form Is Needed
The IRS offers some common-law guidance on how to determine if a worker should receive a Form W-2 or Form 1099. Employers should weigh all three factors outlined by the IRS when determining which form to use.
- Behavioral: Does the company control, or have the right to control, what the worker does and how the worker does his or her job?
- Financial: Are the business aspects of the worker’s job controlled by the payer? (These may include how the worker is paid, whether expenses are reimbursed, who provides the tools and supplies, etc.)
- Type of Relationship: Are there written contracts or employee-type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue, and is the work performed a key aspect of the business?
How a worker is classified directly affects the taxes of the worker and the employer. Misclassifying an employee can result in IRS audits, fines, and even employment lawsuits from the misclassified employee.
IRS Audits and Fines
State and federal authorities do not receive the correct amount of taxes they should when an employee is misclassified, which can lead to a potential IRS audit that may result in large fines for the company. Employers could be responsible for paying the missing state and federal payroll taxes, as well as Social Security and Medicare taxes, for any employee found to be classified incorrectly. There is also a potential I-9 issue with misclassification. All employers are required to have a correctly completed I-9 Form on file for all W-2 employees. If an employee should have been classified as a W-2 employee, but was classified as a 1099, the employer will also face fines for failing to collect the I-9.
Misclassifying an employee leaves the company vulnerable to potential for wage claims. If an employee is misclassified, the employer is violating wage, tax, and employment eligibility laws—both state and federal. In this case, employers can be held liable for failing to pay overtime and minimum wage under the Federal Fair Labor Standards Act (FLSA), in addition to any state-specific, or county-specific, wage and labor laws. Wage claims can even go as far back as three years if a violation is found.
If you need assistance on whether to hire a 1099 or W-2 worker, or are looking for guidance on classifying existing workers, Harbor America and our team of experts is here to help. Our human resource management professionals provide expert guidance and up-to-date industry knowledge, so you receive the most accurate advice on all your business needs. We also offer compliance support on any government legislation and regulations, including FLSA. We are available to assist with any compliance-related questions pertaining to employee and employer taxes as it relates to W-2s and 1099s. Contact Harbor America to get started.