Deciding between a contract worker and a standard employee can be a frustrating task, especially for small businesses where the owners or HR managers are not trained in strategic decision-making. This decision ultimately comes down to what fits your business best, which requires looking at multiple factors such as the cost of hiring, flexibility, commitment, tax, and other legal matters.
This is why in this article we will attempt to make it easier for you to decide which option should be best for your business.
First, we must understand the core difference between these two designations.
What is a 1099 Worker?
1099 workers are self-employed workers or contractors. They can also be called freelancers and are a part of the rising gig economy. They get their name 1099 from the IRS form that reports their income and tax details. 1099 workers sign or verbally commit to a contract with the business and perform their work according to the terms and conditions agreed. Once their contract has been executed, they and the business go their separate ways.
What is a W2 employee?
W2 employees are standard employees that are hired through a regular hiring process and appear on the payroll of a business. The name W2 comes from the W2 form containing the compensation received and the tax benefits. The W2 form is filed by the business that hires the employees.
W2 employees are regular employees of a business, which means that they receive regular pay, benefits and go through appraisals and promotions.
Both 1099 workers and W2 employees come with their own risks and benefits, which is why it is essential for business owners to know what each of these workers bring to the table, to make the right hiring decisions.
The biggest differentiating factor between W2 employees and 1099 workers is the cost-saving. Standard employees are paid thru the payroll of the business, and this binds the business to certain laws and regulations.
Standard employees cannot be paid below the minimum wage, they may receive other benefits like health insurance and retirement, and the business must pay them for overtime. In addition to all this, the business needs to manage its tax, insurance, and legal paperwork, which adds administrative costs for the business.
Compared to W2 employees, 1099 workers are lighter on the budget. Since they are contract workers and not on the payroll.1099 workers do not have to be provided with health insurance or other benefits, which certainly reduces the administrative paperwork and cost for the business. Contract workers simply are paid for the work done, at the agreed rate.
Three key risk areas that can end up costing money to a business are
1. State unemployment audit
2. Reclassification of 1099 workers to W2 employees
3. Work compensation claims
State unemployment audit
State revenue department audits are carried out to fine unreported unpaid unemployment tax from businesses. If the auditors reclassify your 1099 workers as W2 employees, your business will owe additional unemployment tax. In addition to this, the state may report or share the information of your business payroll with the IRS. This may trigger a second audit that may possibly lead to a bigger penalty.
Reclassification of 1099 workers to W2 employees
IRS estimates suggest that it has lost over $34.7 billion in taxes due to the misclassification of W2 employees as 1099 workers. If IRS feels that the business has classified its workers wrongly, either unknowingly or to avoid taxes then an IRS audit may be triggered, leading to penalties.
For this reason, the IRS has a set of 20 questions that businesses can use to determine the status of their workers. These 20 questions have been divided into three main categories namely,
1. Behavioral control
2. Financial control
3. Type of relationship
In simple terms, if the business has a great degree of control in all three aspects, then the worker is likely to be classified as a W2 employee.
Workers Compensation Claims
Incorrect classification of 1099 workers may create the additional risk of a lawsuit and penalties in case of any work-related injury or claim. To avoid this risk your business can voluntarily provide workers' compensation coverage to 1099 contractors as if they were W2 employees. This will add a slight cost, but it will mitigate the risk of any disgruntled worker complaining to the IRS, which may lead to bigger losses.
Managing cash flow has been the biggest factor that helped businesses survive during the pandemic. Since 1099 workers come with very few strings attached, they have an edge over W2 employees when it comes to managing cash flow and budgeting. Businesses might prefer to hire contract workers because their working hours and working requirements can be arranged to meet the situation more readily compared to standard employees.
Contract workers also carry the added benefit of being specialists in what they do, which means that the business does not have to provide training or orientations. They can simply be hired for a specific job and get it done without knowing anything more about the business. For freelancers working on outsourced tasks, this can help the business with specialized skills, think Fiverr or Upwork.
When it comes to commitment and growth, W2 employees have a clear edge over 1099 workers. While the pay and benefits are motivating factors, standard employees also seek to learn and grow from the environment of the business where they work.
Contract workers cannot be inculcated with the culture, norms, vision, and objectives of the business because they are only there to do the job they have been hired for. Standard employees, on the other hand, are a part of the business, an asset in other words, and therefore put their blood and sweat into their work. If you’re thinking of one day retiring or selling your business, W2 employees can be a very effective way to succession plan
To conclude this discussion, balancing the best type of worker is about what suits your business in the given situation with the cost and risks. Contractors are best for short-term work, non-core activities, or specialized tasks. Standard employees are best for long-term work, in-house skill development, and core activities of the business.