Form 1099-NEC vs. Form W-2: How to know the difference?

Sometimes the difference between an independent contractor and an employee can seem confusing. The distinction is based on U.S. tax law, and it's really about how much control you have over the person's time and how they get the job done. Understanding the difference between the two, and when to make use of each, can help you make smart staffing decisions for your business.

What is a Form W-2 employee?

This is what we typically think of as an employee. The name comes from the IRS Form W-2 you give them and file with the IRS once a year, that reports their income and all taxes withheld.

Specific federal laws define your relationship to these workers. You generally pay them a regular salary or hourly rate in exchange for their work. They could be eligible for benefits such as sick leave, paid vacation, retirement plans and insurance. In exchange, you have a little more control over the employee and their activities. You decide what they work on, how many hours they work, and where, when and how they perform the work. You may also be required to provide the tools and supplies they need to do their job and reimburse them for business expenses.

Their employment term is typically open-ended, meaning they could be on the job until they quit or you dismiss them. For this and other reasons, you'll want to make hiring decisions carefully. As an employer, you may need to withhold Social Security, state and federal taxes, and other deductions from these workers' salaries. Federal and state minimum wage laws also apply to these workers. Because of all the additional rules that govern these workplace relationships, when in doubt it might be safer to classify a worker as an employee rather than an independent contractor.

Benefits of hiring a Form W-2 employee

• More control over their job duties and schedule
• Ability to assign or request overtime when you have more business
• Ability to train for additional responsibilities as needed
• Stable relationship with no set end point
• Ability to fire or lay off the worker
• Covered by worker's compensation insurance, decreasing your legal liability

What is a Form 1099-NEC independent contractor?

A worker other than an “employee” is usually an independent contractor. You must give them a Form 1099-NEC for tax purposes. These workers negotiate their own compensation as part of a contract with you and may work for a set amount of time, often on a per-project basis. Independent contractors get work done on their own schedule, using their own tools and supplies.

An independent contractor is usually less expensive than an employee for a business, because there are no taxes or benefits to pay. An independent contractor is also responsible for paying their own work-related expenses, Social Security and taxes. For this reason, it's often simpler for a business to classify a worker as an independent contractor. However, you must be sure you're doing this correctly, based on IRS criteria. If a worker is paid like an independent contractor but does not meet the IRS description, the IRS or Department of Labor can issue you a fine.

Using independent contractors can be a great way to grow your business or avoid making the wrong hire before you know exactly what you need to look for in an employee.

Benefits of hiring an independent contractor

• Do not have to pay payroll taxes
• Do not have to pay benefits
• Gain specific expertise for a short-term or one-time project
• Have more flexibility in how long they will be working with you
• They provide their own equipment and tools

How to determine whether a worker is an employee vs. an independent contractor

If you incorrectly classify an employee as an independent contractor, you may have to pay the back taxes owed for that employee. For that reason, it's important not to identify workers as independent contractors unless you are positive that they are truly independent.

The IRS sets out three main distinctions for determining whether a worker is an employee or an independent contractor.

• Behavioral. If you have control over where, when and how the person does their job, they are usually an employee and not an independent contractor.
• Financial. Do you pay the worker a regular salary, or is compensation based on a contract between you and the worker?
• Type of relationship. How long a person works for you, and whether they only work for you or for other businesses as well, can help you determine whether the person is an independent contractor.

Here are some additional ways to tell whether a worker is an independent contractor:

• They are paid by the job. You don't pay the worker wages or a salary on a regular basis, but instead pay for a completed project.
• They work for multiple companies. An independent contractor might take work from various businesses, instead of working full-time exclusively for one company.
• They have their own employees. A contractor who runs their own independent business may have their own assistants and other workers, even their own employees.
• They set their own hours. When working with an independent contractor, you can require them to finish the job by a certain deadline, but you might have little or no say over when, where or how they do the work.
• They have their own equipment. A contractor might use their own tools, computer, software and other supplies, rather than have you provide them.

When you decide whether to work with an independent contractor or a Form W-2 employee, you'll have to make some decisions about how much control you want to have. Either way, you'll need a stable business banking account to manage bill paying, payroll, and other expenses. Speak with a business banker and learn how we can help your small business.