More workers have become independent contractors in recent years due to the growing gig economy, the rise of remote work, and the ongoing labor shortage.
While independent contractors are often referred to as 1099 employees, they technically aren't employees of the organizations they work with. Knowing the difference between employees and contractors is essential for any employer or HR department to avoid tax penalties or lawsuits due to misclassification.
This article will explain what a 1099 employee is, how they differ from W-2 employees, and what rules you need to know when hiring a contractor.
Want to offer employee benefits to your 1099 employees without impacting their status? Learn more about offering employee stipends in our guide
What is a 1099 employee?
A 1099 employee is an independent contractor. The name derives from the Internal Revenue Service's (IRS) Form 1099 that contract workers must complete to report their earnings.
Freelancers, consultants, self-employed workers, and sole proprietors are common types of 1099 employees. This includes gig workers, such as Uber or Lyft drivers and Airbnb hosts.
In most cases, an independent contractor is a temporary worker who organizations pay to complete specific duties or tasks. These projects can sometimes be long-term, but the understanding is that the organization will no longer employ the contractor at the end of the project.
Contractors generally work under a written contract with an organization that outlines what is expected of each party. While these contracts are sometimes exclusive, many contractors work for multiple clients and projects at a time.
What is the difference between a W-2 and a 1099 employee?
There are two primary types of workers: W-2 employees and 1099 employees. A common question from business owners and HR professionals is regarding the difference between W-2 employees and 1099 employees. Let’s break down the differences.
W-2 employees are workers directly employed by your organization. These workers, also known as regular employees, are guaranteed to earn at least the minimum wage, and many state and federal laws apply to benefits and overtime hours. Employers also withhold Social Security, Medicare, federal income, and FUTA taxes for these employees.
Most employers are expected to provide their W-2 employees with the necessary tools and supplies for them to do their jobs. They are also eligible for employee benefits and other perks.
In contrast, contractors work for themselves. They are responsible for providing their own tools and equipment, setting their schedules, and paying their income taxes and other applicable forms of self-employment tax.
What qualifies someone as a 1099 employee?
As an employer, you can't classify regular workers, such as full-time employees, as independent contractors. Misclassifying an employee as a contractor can have severe tax and legal consequences, including the employee suing your organization for back pay and benefits eligibility.
The Fair Labor Standards Act (FLSA) established a series of tests to help organizations determine their workers' employee status and avoid employee misclassification.
According to the IRS, three categories can help determine classification:
- Behavioral: Do you or your organization have the right to control what your worker does and how they do their job? If you do, they are likely employees, not contractors, depending on the degree of control.
- Financial: Are business aspects such as how the worker is paid, whether expenses are reimbursed, and who provides tools and supplies controlled by the payer (or employer)? If your organization has financial control, your worker is probably an employee.
- Type of relationship: Are there any written contracts or employee benefits? Will you continue your professional relationship with the worker once their work is complete? If you have a written contract, your worker could be a contractor. However, if they are hired permanently, they might be an employee.
Depending on your answers to these questions, you should be able to tell if your workers are contractors or W-2 employees. The key is to look at the relationship between your organization and your workers.
Sometimes, it can be challenging to tell how to classify a position. In these cases, you can fill out Form SS-8, and the IRS will review it to officially determine your worker's status.
Why do organizations hire independent contractors?
There are many advantages to hiring a contractor. They’re often more specialized in their fields, allowing you to take advantage of their expertise for specific projects. They also provide greater flexibility because you can hire them for short-term projects as you have the budget instead of hiring a traditional employee.
And, because contract workers aren't directly employed by your organization and usually have their own insurance, you have less legal risk. They also aren't eligible for workers compensation insurance.
Another reason organizations hire contractors is that organizations don't need to provide employee benefits, such as health insurance or health reimbursement arrangements (HRAs), to their contract workers. While this isn't required, offering benefits such as employee stipends can help your organization attract and retain 1099 employees without impacting their independent status. That's because stipends are considered taxable income.
Finally, many contractors work remotely. This allows organizations to save money on office space.
Why do workers choose to become independent contractors?
There are many reasons someone chooses to become a contract employee, including:
- Flexible working conditions
- More free time/time off
- More control over who you work for
- Greater income potential
Because independent contractors are essentially their own bosses, they have control over how and where they work and for how long. They can choose their own schedule as long as they deliver the work promised in their contract., giving them more time to spend with family, pursue their hobbies, or take on additional contract work for other organizations.
Contract workers can earn more than W-2 employees with a good business strategy. That's because they are often highly skilled and in constant demand. By taking on multiple clients, they can also increase their income and diversify their skills.
However, despite all the perks of becoming a contractor, the lifestyle isn't for everyone. There's no safety net for income or job stability, and there's a lot more work involved with doing your own taxes and managing your time. Because organizations don't make payroll deductions, contract employees must ensure they have adequate funds to pay their taxes.
Contractors are also responsible for any business expenses, travel expenses, or other costs of self-employment.
How does a 1099 employee get paid?
When hiring a contractor, you'll need to decide how you'll pay them, how often they'll be paid, and what the measurables are for payment.
Three primary ways to pay contractors are hourly, by retainer, or on a project basis. Contractors don't receive a salary because the IRS looks at that as criteria for employee classification. They also don't receive overtime wages, which is reserved for employees.
No matter which payment method you and your contract employee choose, be sure to draft a written contract outlining your decision.
Since contractors aren't employees, you don't need to withhold or file taxes. You also aren't responsible for payroll taxes, unemployment insurance, or business expenses.
You report the earnings of your contractors with Tax Form 1099-NEC if you've paid a contractor more than $600 during the tax year. However, if your contractor has already established their own C-corp or S-corp, you don't need to file this form. You will always furnish a Form W-9 to contract workers.
Previously, employers used Form 1099-MISC to report earnings for contractors. However, the IRS replaced it with the 1099-NEC Form. This form is now only used for income from rent, legal settlements, or prize winnings.
Independent contract workers can play an essential role in your organization. Knowing the distinction between employees and contract workers will help you avoid legal trouble while taking advantage of the flexibility and cost savings of hiring freelance workers.
If you're looking to attract highly qualified contract workers, PeopleKeep can help! Our employee stipend administration software allows you to create and offer custom perks for health, wellness, remote work, education benefits, and more. With WorkPerks, you can offer benefits to your contract employees while allowing them to maintain their independent contractor status.
Get in touch with a personalized benefits advisor to see how stipends can help you attract freelancers