W-2 and 1099: The Difference and Why It Matters
It's important to understand how the IRS determines 1099 vs. W-2 worker status to prevent costly fines or penalties for misclassification. Here's what you need to know.
As a business owner, it's important to understand how the IRS determines 1099 vs. W-2 worker status, as there are costly penalties or fines for misclassifying employees as contractors. To help reduce the chances of tax errors and other compliance issues, you should know the purposes of both forms and the types of workers they represent.
What is Form 1099?
Form 1099-NEC is used for reporting non-employee compensation or independent contractor income. The IRS says the worker is generally an independent contractor for federal tax purposes "if the person for whom the services are performed has the right to control or direct only the result of the work and not what will be done and how it will be done." Earnings from independent contractors are also typically subject to self-employment tax. Common examples of independent contractors are graphic designers, web developers, cleaning professionals, freelance writers, landscapers and other self-employed individuals.
You should furnish and file Form 1099-NEC if you have paid a contractor more than $600 in a tax year. In general, you don't need to furnish or file Form 1099-NEC for independent contractors that are taxed as a C corporation or S corporation.
You should also be mindful that Form 1099-NEC replaces Form 1099-MISC box 7 for reporting non-employee compensation. Prior to tax year 2020, if a business hired contracted work, they would need to issue a 1099-MISC to the freelancer or independent contractor. This form is still around, but it's used to report miscellaneous income, such as rents, prizes, awards, royalties, healthcare payments, and payments to attorneys.
What is Form W-2?
Form W-2 is a wage and tax statement you issue to employees and file with the IRS. According to the IRS, when an individual performs services that are controlled by you, and you are the one that determines what will be done and how it will be done, the individual should generally be classified as an employee for federal income tax purposes. Every employer engaged in a trade or business who pays remuneration to an employee for services performed, including non-cash payments, of $600 or more for the year must furnish and file Form W-2.
File Form W-2 to report wages, tips and other compensation paid to an employee. You must report the employee's income and Social Security taxes paid to both the employee and the IRS. You also need to report wage and withholding information to the employee and the Social Security Administration (SSA). Subsequently, the SSA will share the information with the IRS. These same rules apply for any remote employees who are on your payroll.
Be careful when filing
You can face repercussions for using the wrong tax form and misclassifying workers. If you misclassify a worker as an independent contractor, you risk increased tax bills and penalties for not paying the appropriate employee taxes and for using the wrong form. You may also be subject to penalties for failing to take appropriate state withholding and deductions, as well as levies for not contributing to state disability and unemployment agencies.
The IRS penalty per statement for failure to timely file accurate and complete forms (including accurate names and Social Security numbers) is up to $310 per statement for 2024 and $330 for 2025
There are two tiers of possible penalties:
- If the employer correctly identified the worker as employee/contractor and issued a Form W-2/1099, but failed to withhold, they may be subject to an additional 20% added to FICA rates and 1.5% to the proper amount of income tax expected from the employee (due from the employer).
- If the employer failed to issue Form W-2/1099 correctly, they may be subject to an additional 40% added to FICA and 3% to income tax, and up to 100% of the matching FICA taxes the employer should have paid, if they are found to have acted willfully.
Furthermore, due to the Fair Labor Standards Act (FLSA), employers could be liable for unpaid overtime for any misclassified workers. According to the IRS, if the worker is an employee, "you must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to an employee. You do not have to withhold or pay any taxes on payments to independent contractors."
Need help classifying workers?
When you're making a 1099 vs. W-2 tax form and worker classification decision, you must have a complete and accurate understanding of the business relationship between your organization and your workers. The IRS provides important information regarding this relationship and offers common law rules to help small businesses make the correct classifications for federal income tax purposes.
If you're experiencing difficulty in making a determination, you can use Form SS-8, called "Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding," and file it with the IRS, who will then officially make this determination for you.
It's important to note that the IRS classification test applies for federal income tax purposes, but there are different federal tests that could apply for different purposes (such as the DOL test for purposes of the FLSA). In addition, several states have adopted their own classification tests, the most prevalent one being the "ABC Test."
Businesses should also be aware that it may be necessary to file forms 1099-NEC with the state tax authorities. Although some states participate in the Combined Federal State Filing Program where the IRS forwards the form to the state, many states require businesses to file these forms with the state directly.
Keep in mind that the IRS does offer a Voluntary Classification Settlement Program (VCSP), which gives businesses the opportunity to reclassify workers as employees for future tax periods. The program provides partial relief from federal employment taxes. Certain eligibility requirements apply.
As always, consult a legal or tax adviser if you have additional questions about these issues or are unsure of how to treat a particular worker. These professionals can provide expert guidance regarding your circumstances and help you navigate specific tax and legal requirements applicable to your situation.
Automate how you manage your freelancers, 1099 contractors, and contingent workers through WorkMarket®, an ADP company.
This information was updated in January 2025.
