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1099 vs. W-2 Employees: Key Differences and How to Determine Which Is Correct

Spark Team

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Misclassifying employees can be a costly mistake, with significant financial, civil and even criminal penalties. 1099s typically refer to freelancers, contractors, consultants and other short-term jobs while W-2 employees are the standard worker classification. By understanding the tests used to determine which workers fit into specific categories, make the right employment decisions for your organization.

When should workers be 1099 vs. W-2 employees for your organization? Getting it right is crucial as misclassification can result in significant penalties.

Employers will sometimes refer to independent contractors as "1099" workers and employees as "W-2" workers based on the IRS forms used for reporting purposes. However, simply providing someone with a 1099 form doesn't mean you've put them into the right group.

The 1099 vs. W-2 classification must be made on the basis of whether the worker meets federal and state tests for independent contractor status. Different tests are used to determine whether a worker is covered by a particular law or benefit.

Here's an overview of some of these tests as well as a closer look at the difference between the two worker types.

What's the difference between W-2 and 1099 employees?

The major difference between regular employees and freelancers or independent contractors is their employment and tax status.

W-2 employees

A W-2 employee is typically on an organization's payroll and hired for an indefinite amount of time to complete ongoing work. Taxes are withheld from their checks and remitted to the state and federal government as required. Organizations also pay employment taxes and make Social Security and Medicare contributions for W-2 employees. These workers are also eligible for legal protections and benefits such as overtime, health insurance and more.

Some examples of common W-2 workers:

• Hourly employees in labor, customer service and similar roles
• Salaried employees who complete daily tasks required by the organization
• Executives and management throughout the organization

1099 workers

By contrast, a 1099 worker runs their own operations and often has multiple customers or clients they work with. They take care of their own costs of doing business and are responsible for reporting and paying the taxes on their income. They don't have access to employment-related legal protections or receive employment-related benefits from anyone who hires them.

Some examples of common 1099 workers:

• Freelance talent such as writers, photographers and graphic designers
• Consultants offering a one-time or limited scope of service
• Gig workers who complete tasks or projects, sometimes using online platforms or apps
• Contractors who may be hired through temp agencies or other vendors

At a glance: 1099 vs. W-2 employees

How to decide what's best for your business

When you're deciding whether a potential hire should be a W-2 employee or an independent contractor, it's important to take a closer look at the rules and regulations explored more in-depth in the next sections. However, there are also factors that come into play as you're first considering creating a role and how you'll use that person's services that can guide your decision to the right classification upfront.

Key factors to consider include:

• The amount of work required. Is this a one-time project or a skill you need access to on a limited basis? Or do you envision a steady stream of duties that are usual for your type of organization?
• Talent availability. In certain fields where it's difficult to hire full-time talent, working with a 1099 employee can give you access to skills that are in short supply. This may require reimagining how you work with the individual. For example, a cybersecurity consultant might design a program that your IT team implements rather than having them own the entire initiative from start to finish.
• Compensation. Freelancers and independent contractors are responsible for the profit and loss of their business and set their own rates. Often, the hourly or project rate may be higher to account for self-employment taxes, business expenses and other costs. By comparison, when hiring a W-2 employee, you'll need to factor in the cost of their salary and any bonuses, paid time off, benefits and the employer's share of taxes to weigh the total costs.

Various tests for 1099 vs. W-2 employee classification

With those factors in mind, you can look to the Internal Revenue Service (IRS), Department of Labor (DOL), the Equal Employment Opportunity Commission (EEOC) and individual states to help you identify whether a worker is considered an employee or is more clearly a freelancer or independent contractor.

IRS common law rules

The IRS uses common law rules for federal tax purposes. The test has three broad categories to determine the appropriate classification of a worker:

• Behavioral control. This aspect examines whether the company has the authority to direct and control the work of the service provider and looks at whether the worker receives training and instruction.
• Financial control. This factor weighs whether the worker realizes a profit or loss, makes investments in tools and facilities and has unreimbursed expenses from the work.
• Type of relationship. This look at the nature of the work arrangements includes whether there is a written contract between the parties, the permanency of the relationship and whether the person is entitled to employee-type benefits.

Under this test, no one factor stands alone in making a classification determination. You need to weigh all factors and take into account other applicable tests when determining whether an individual is an employee or an independent contractor. Look at the entire relationship, consider the degree of control, and document each of the factors used in making a determination.

When in doubt, err on the side of caution and classify the worker as an employee. You may also request an official determination from the IRS using Form SS-8. However, it can take months to get an IRS determination.

DOL economic reality test

The DOL uses an economic reality test to determine whether workers are covered by the Fair Labor Standards Act and entitled to minimum wage, overtime and other pay- and time-related protections.

Under this test, the following factors are considered significant:

• The extent to which the services rendered are an integral part of the principal's business
• The permanency of the relationship
• The individual's investment in facilities and equipment
• The nature and degree of control by the principal
• The individual's opportunity for profit and loss
• The amount of initiative, judgment, or foresight in open market competition with others required for the individual's success
• The degree of independent business organization and operation

Equal Employment Opportunity rules

Under federal nondiscrimination laws, a worker is presumed to be an employee and entitled to legal protection unless they don't meet certain criteria. The EEOC has guidance documentation that lists factors indicating when a worker is an employee and not an independent contractor, such as whether:

• The employer has the right to control when, where and how the worker performs the job.
• The work doesn't require a high level of skill or expertise.
• The employer furnishes the tools, materials and equipment.
• The work is performed on the employer's premises.
• There is a continuing relationship between the worker and the employer.
• The employer has the right to assign additional projects to the worker.
• The employer sets the hours of work and the duration of the job.
• The worker is paid by the hour, week or month rather than the agreed cost of performing a particular job.
• The worker does not hire and pay assistants.
• The work performed by the worker is part of the regular business of the employer.
• The worker is not engaged in their own distinct occupation or business.
• The employer provides the worker with benefits such as insurance, leave or workers' compensation.
• The worker is considered an employee of the employer for tax purposes (i.e., the employer withholds federal, state and Social Security taxes).
• The employer can discharge the worker.
• The worker and the employer believe that they are creating an employer-employee relationship.

Individual state employee classification tests

Some states have their own tests, some of which are more difficult to satisfy than federal tests. For example, a number of states use the ABC test to determine whether an individual is covered under unemployment insurance and/or wage and hour laws or other benefits.

Under this test, a worker must be considered an employee unless all three of the following factors are met:

• Absence of control. The worker is not under the explicit direction of the organization in performing the work.
• Business is unusual. The worker performs work that is outside the normal course of the organization's business and/or does the work off-site.
• Customarily engaged. The worker typically works independently in an established trade, occupation or business of the same nature as the work performed for the organization.

The ABC test is not a universal list of factors in all locations, however, so check your applicable state laws and regulations to ensure compliance.

Penalties for miscategorizing an employee

The penalties for miscategorizing an employee can be staggering. If an employee is miscategorized as a 1099, the employer can be fined and held liable for unpaid employment taxes and for not paying according to minimum wage laws and/or overtime in connection with any state and federal laws. If there's a significant pattern of behavior or the Department of Labor suspects a misclassification was willful, the employer may even face criminal charges. There's also potential exposure to civil lawsuits from affected workers. So, it pays to stay in compliance.

The bottom line

Before classifying an individual as an independent contractor, make sure they've met all of the defining requirements. If the worker fails to pass these tests, they may be considered an employee and entitled to all the rights and benefits of employees under all applicable laws.

Automate how you manage your freelancers, 1099 contractors, and contingent workers through WorkMarket^®, an ADP company.