Employee misclassification is a problem that has persisted in growing industries – employers labeling workers as independent contractors rather than employees and allowing them to bypass paying unemployment and additional taxes on their workers. In the U.S. alone, 10% to 30% of employers misclassify their employees as independent contractors.Whether you’re a small business or a large enterprise, there's no denying the advantages of hiring a freelance worker. As a company expands, onboarding and tax forms are two requirements that can bog down the hiring process and muddy the waters of skilled talent.
While companies may cut costs by misclassifying their employees, the charges for such a penalty (whether intentional or unintentional) can result in a hefty fine or potential criminal charges. If the IRS suspects fraud or intentional misconduct, this could lead to an employer facing criminal charges of up to $10,000 per misclassified employee and up to five years in prison.
The forms a new worker fills out will speak volumes about their role in the company. And with misclassification fines looming over the head of every business owner, filing the proper tax forms with the appropriate tax withholding, is critical to running a sound business. It also means you are less likely to be audited during tax season.
In this article, we’ll explore the difference between a W2 and a W9 worker, including how that relates to form 1099, hiring differences, tax rates, and choosing which class of worker is the smartest decision for your business.
What is the Main Difference Between Employees and Independent Contractors?
Although a business might pay an employee and an independent contractor for the same type of work, that’s where the similarities stop. An employee is the responsibility of the employer in the eyes of the IRS. If you have your own business with regular employees, you must withhold income tax, Medicare, and Social Security from the wages you pay them.
For an independent contractor, companies do not have the responsibility to withhold state income tax or federal tax. No laws apply for minimum wage, health insurance, workers’ compensation, or overtime. The worker is a sole proprietor that is self-employed and is responsible for their own self-employment tax.
What is a W2 Contractor?
There is a difference between a W2 employee and a W2 contractor. A W2 contractor is an individual who is essentially employed by a third-party agency. The temporary recruiter issues the W2 form, but the worker is still loosely considered a contracted employee in the daily work environment. This is a shady area and is often the center of misclassification issues.
Given these two definitions, it seems impossible to be labeled a W2 contractor. However, the temporary agency that files the paperwork for the contractor is actually considered the employer. Thus, they are responsible for deducting taxes and issuing a W2 when applicable. Meanwhile, this individual works for the business paying the temporary work agency.
When a freelancer signs up with the third-party agency, they will fill out Form W4. With this document, the temp agency will determine how much to withhold from their paycheck. When the tax year ends, it is the agency that is responsible for mailing out a W2, not the business using the contracted worker. This is part of the reason why a smaller business might choose to work with a temp agency in the first place. There is less of a paperwork headache.
This Contractor Works Best For:
- When a business needs someone quickly; without an in-depth vetting process
- They prefer a third party to maintain tax paperwork and documentation
- May be looking to hire permanently, but want to test the waters with a risk-free alternative
- Willing to pay a higher rate for the convenience of no commitment
What is a W9 Contractor?
When hiring freelance workers or independent contractors, the very first step is to address tax time and the corresponding paperwork. The contractor needs to fill out a W9 form that’s officially called a “Request for Taxpayer Identification Number and Certification.” The purpose of this document is to gather tax information directly from the freelancer to ensure precision with your audit trail.
If a business pays someone considered a non-employee more than $600 in a year for their service, it must file what’s called an information return. The accuracy of this information return is verified by the data the contractor directly gives you when filling out a W9 form.
A W9 requires a signature, which certifies:
- The tax ID number (TIN) is correct
- The other party is not subject to backup withholding
- The other party claims exemption from backup withholding
- The FATCA code used (along with the freelancer’s exemption status)
A company will use the name (or business name), address, and TIN (or more commonly, social security number (SSN)) that a contractor provides on the W9 to complete the required information return. A business must also safely secure all of these documents to guarantee personal and private data is protected.
This Contractor Works Best For:
- When a company needs someone for a one-off job or a short-term commitment
- You have the time to investigate a worker’s background
- Don’t have the funds to hire more full-time employees
- Need an individual to take responsibility for their own taxes
What is a 1099 Contractor?
A 1099 contractor is synonymous with a W9 contractor, which is an individual that provides goods and/or services to a business, based on a freelancer agreement. Unlike a regular employee, an independent contractor only works when required and is responsible for their own tax payments. With these workers, there is no withholding payroll taxes or other related expenses that would apply to permanent employees. These individuals are mostly free to do as they like.
1099 Freelancers are not eligible for employee benefits, 401K, or paid vacations. A business is required to fill out form 1099-NEC, which is the income-reporting document sent to contractors at the end of the year (no later than Jan 31). If these freelancers have earned more than $600 in the year, they can report and pay on the earnings you sent them. A copy of these documents must always be sent to the IRS.
This Contractor Works Best For:
- A business that still needs to keep track of workers at year-end
- When you need someone for a simple task or short-term commitment
- Don’t have the funds to hire more full-time employees or part-time W2 workers
- You’d rather the freelancer take care of the paperwork and taxes
W2 vs W9 vs 1099 Contractors: Hiring Differences
When hiring an employee for your business, the process is simple. You have them fill out a W2 form with all corresponding data like name, address, and SSN (the payer data too). It’s a general investment, and soon after the ink is dry on the documents, training begins. Onboarding can be a lengthy process where a business owner is fully expecting people to stick around.
A W9 or 1099 contractor, on the other hand, is typically less expensive than a W2 employee, and is available to immediately accomplish the tasks at hand. There is no training process, as these workers are ready to hit the ground running. However, the downside to this type of help is their inordinate amount of freedom. Flexibility comes with a price and the best 1099 workers are not always available when you need them.
While a W2 employee should expect a typical 9-5 workday, a freelancer might choose to work one day at noon and the other at midnight. As long as the work is completed, the business has little say in how those goals are accomplished.
Additionally, W2 employees should be entered into payroll and expect a paycheck. In some cases, this may even be in the form of a paper check. A freelancer typically drives the narrative on payments and will use the contract to designate their preferred method. (Hint: it’s usually direct deposit).
W2 vs W9 vs 1099 Contractors: Tax Rates
Employment tax, such as Medicare taxes and Social Security taxes, amount to approximately 15.3% of a worker’s gross wages. An employer pays half of this (7.65%) and then withholds the other half from W2 employee paychecks. On the other hand, W9/1099 contractors pay the entire 15.3% tax themselves on the money they earn. This hardly seems fair.
Although it may appear like the hourly-wage employee comes out on top, a 1099 contractor can actually receive more tax deductions if they know what they’re doing. This includes everything from mileage to meals, home office expenses, the internet, work phone, general utilities, team training events, and other business expenses that will lower taxable income. Thus, contractors may end up paying a smaller tax rate than W2 employees.
W2 vs W9 vs 1099 Contractors: Tax Forms
An official W2 form is provided to a worker at the end of the year so they can file a tax return. In this respect, a business is claiming responsibility for an employee’s taxes, whether they are full or part-time. A W2 summarizes an employee’s wages for the year, and how many tax dollars were withheld and sent to the IRS. A copy of this form is also sent to the IRS so they also have an accurate record of the employee’s wages.
A Form W9 is used to prepare informational returns to the IRS. If a freelancer receives more than $600 in a calendar year from a business, an organization is to send Form 1099-MISC and the contractor must self-report their own taxes.
The purpose of a W9 form extends beyond a single scenario. A bank and other financial institutions rely on the receipt of taxpayer data in order to properly report Form 1099-INT, 1099-B, and 1099-DIV. A taxpayer may also be asked to furnish form W9 for student loans and real estate transactions.
A 1099 contractor always deals with two other forms. IRS form W9 is handed into an employer when the freelance contract is signed and the job is started. When the tax year comes to a close, the company doing business with the freelancer is expected to send out a 1099 tax form, aggregating all of the freelancer's earnings for the year.
Summary Table of Differences: W2 vs W9 vs 1099 Contractors
When it comes to negotiating tax forms and worker status, it’s not always a straightforward process. Dealing with tax forms is a complex process, especially for small business owners. Allow the contractors to lead the way when it comes to filling out their own tax forms for hiring. As a business owner, your top priority is interviewing top talent and getting the best people onboard.
Here’s a simple table for a quick and easy comparison:
Final Thoughts: Which Contractor Should You Hire – W2 or W9 or 1099?
Whether a worker files a W2 or 1099 with the government, they’re both being paid to perform a job. But, the big difference is employment status. W2 workers are hired by a business and are considered part of the company. Buy-in and brand loyalty from these workers will be a lot stronger.
1099 contract workers, however, may just be there for you when no one else is around. When hiring these types of workers, don’t worry about their taxes. The responsibility lies on them to stay in good standing.
Hiring a W2 worker is ideal for a smaller business that needs brand loyalty to grow. Although building a business is a lot easier with temp workers, they will not always stay to see things through. There is every little commitment. Therefore, a company should hire a W2 worker when seeking a deep level of loyalty that contributes to brand growth.
If a business wants to save money in the long term, while tapping into niche expertise, a W9/1099 worker is the prime choice. These experts don’t waste time and will be ready to work the second they are hired.
As is apparent, different tax forms carry varying legal ramifications. The implications of a W9 and 1099 worker are vastly different than that of a W4 and W2 employee. It’s critical you realize these differences before hiring the wrong person to do the job.
Lumanu is an online payment system that can be used to pay a worker of any status. The solution fills the gaps for a company that wants to dip its toes in the gig economy pool. The platform handles a multitude of actions surrounding partner payments, from bookkeeping and accounting to tax form collection, onboarding exercises, and even access to working capital. Click here to schedule a demo with Lumanu today.