There are many different types of workers from temporary, full-time, part-time, to freelancing/gig economy work. Yes, the gig economy (think driving for Uber/Lyft, delivering food with GrubHub, and more) is skyrocketing with many Americans partaking. In fact, 57% of Americans participate in the gig economy and more are freelancing. Freelancing includes providing services like writing, design and data entry to businesses. Freelancers are independent workers referred to as 1099ers as their incomes are reflected on this income tax form.
Conversely, full time and part time employees are nicknamed W-2ers as their incomes are recorded on form W-2. 1099 vs W2 workers have their own unique sets of pros and cons. This post will go into the detail of each employment type and which is better for businesses.
What is a W-2 and who does it apply to?
As mentioned above, form W-2 records an employee’s income, taxes, benefits paid throughout the year. Each employee receives this important form around every January and it’s used to prepare each his or her taxes. W-2s also contain important information like employer/employee addresses, Social Security numbers and EIN (employer identification numbers). The EIN is used by the IRS to identify the employer and reconcile data.
A W-2 also shows the amount employees and employers paid for benefits like 401(k) contributions, HSA contributions, and health care. These factors are reflected by the coded boxes in the top left-hand portion of the form. For example, a few common codes include DD (cost of employer-subsidized health care), V (stock option exercises), D (401k contributions) and W (HSA contributions).
An employer must issue a W-2 form to both full time and part-time employees. These employees report to an employer for a fixed amount of hours per week indefinitely. Also, employers provide employees with specific pieces of training and tasks during the work week. By doing this, employers aim to retain employees for the long term and prevent turnover.
W-2 and Employer-Paid Taxes
In addition, employers must pay substantial taxes on behalf of each employee which include half of FICA tax, FUTA, and SUTA. FUTA and SUTA taxes contribute to an employee’s unemployment compensation, which provides a stream of income in the case of a layoff. FUTA is federal unemployment tax and SUTA refers to each state’s unique unemployment tax laws. These laws might seem complex, but some ways to reduce these taxes include promptly responding to unemployment claims, minimizing turnover, and paying on time. Luckily, these tax rates are minimal and vary between 2-4%. Please refer to this site for each state’s SUTA rules.
Besides these taxes, employers must pay a higher tax for each employee called the Federal Insurance Contributions Act (FICA). FICA is the Medicare and Social Security taxes combined, and is referred to as payroll tax.. Social Security provides a monthly income for retirees and Medicare pays for portions of their healthcare. The total FICA tax is 15.3%, and employers pay half of this amount (7.65%). The employee pays the other half and some highly compensated employees pay an additional Medicare tax of 0.9%. The specific thresholds vary based on filing status, but once an employee earns more than $200K/yr, he or she is usually subject to this surtax.
Pros of W-2 vs 1099 for employers and employees
- Employee Benefits
- W-2 employees receive benefits like paid training, health care (usually for full-time employees only), sick/vacation pay, and are reimbursed for expenses. Quality benefits attract and retain high performers as well as increase morale.
- More commitment
- W-2 employees are with a business for an indefinite period of time and aren’t on a per-project basis. Employees benefit from job security and employers receive value by having consistent workers. Having consistent team members allows employers to easily delegate tasks and free up their time.
- More control
- Employers mainly enjoy this benefit as they have more control over an employee. Employers dictate an employee’s training, daily schedule, and tasks. If an employer needs to have a task completed in a unique way, hiring an employee could be a wise move. Also, some employees prefer stability and a predictable schedule.
Cons of W-2 vs 1099 for employers and employees
- Higher Cost
- Employers pay for employee’s taxes, benefits, pieces of training among other items. These costs can really add up, especially health care for US-based employers. These employers pay on average 82% of an employee’s health care cost, which can stall job creation.
- Increased Legal Complexities
- Employees have more protection than a 1099 contractor. Therefore, employers must pay FICA, FUTA and SUTA taxes for each employee. They must also provide employees with benefits like short term disability, which mandate the employer pay for an employee’s disability leave.
- More Time Commitment
- Employers usually spend more time training and managing them. This is a significant time commitment and many employers are taking less time to train employees. Also, employees generally work a fixed schedule like 8 to 5 PM. Some employees feel restricted by working fixed hours and feel captive.
Best industries for W-2 workers
Whether a company would benefit more from W-2 employees depends on the key aspect of the business. Some industries that cater more to W-2 workers include healthcare, government, and education. Each of these industries is recession-proof, and will always provide jobs. Also, workers in these industries like education are needed throughout the year. W-2 employees are more suitable if there is a steady supply of work. Government jobs are more stable than others since tax revenues support them. The ability to increase tax revenue also enables government employees to receive generous benefits like pensions and premium healthcare.
W-2 employment arrangements are suitable for growing companies that want long term team members. These growing companies must also have sufficient funds to afford all employee expenses to prevent layoffs. Preventing layoffs and having low employee turnover will help grow the business and improve employee morale. In turn, this enhances productivity and attracts top talent to a business.
What is a 1099 and who does it apply to?
Form 1099 is used to record many items, but form 1099-MISC records an independent contractor’s earnings. Some other 1099s, include 1099 G which is used to record taxable unemployment compensation and 1099 B, which reflects taxable interest/dividend income. Employers use form 1099-MISC to inform the IRS how much they paid a contractor. This form contains many important pieces of information like a contractor’s tax identification number, employer address, section 409a income, and any withheld taxes.
A business is required to file this form if they paid a contractor at least $600 in wages, rent, health care payments among others. Section 409a refers to payments made to a deferred compensation plan. This usually occurs if the contractor is a high earning personnel and can include business co-owners.
Independent contractors are also referred to as freelancers or consultants and are considered self-employed by the IRS. Since they are considered self-employed, many individual contractors refer to themselves as small business owners. Contractors can be found in a variety of professions from law, marketing, accounting to landscaping. Some consultants, like lawyers paid on a monthly retainer, are highly compensated, while designers doing infrequent logo designs aren’t. Contractors usually have specific skills and focus on one to two niches.
More freedom, more risk
They generally have more complex skills than employees and are used with less frequent tasks. Therefore, contractors usually have multiple clients and can make their own schedules. Contractors have a greater degree of control, but they also have more risk as they usually don’t receive employee-type benefits like health insurance, life/disability insurance, paid time off or other perks. Contractors also don’t build the amount of rapport a full-time employee does, because they have less staff interaction. In fact, many contractors work online and usually correspond via email or the occasional Skype call.
Unlike employees, contractors are responsible for paying their own taxes, including the entire FICA tax at 15.3% and is referred to as the self-employment tax. In addition, freelancers must pay the federal and state governments in quarterly installments called estimated payments. The US tax system is “pay as you go”, meaning individuals must withhold the right amounts per calendar quarter. Employees don’t have to do this, as their employers withhold taxes from their paychecks every two weeks.
It might seem like contractors have a disadvantage, but they also have more tax deductions. For example, they can use deductions like business mileage, meal deductions, home office expenses, and other business expenses to lower taxable income. By doing this, contractors can pay fewer taxes than an employee would. Another tax advantage that contractors have are higher SEP IRA deduction limits at $56,000 per year. A SEP IRA allows self-employed people to invest monies on a pretax basis, similar to a 401(k). However, 401(k)s have a lower max annual limit at $25,000.
Pros of 1099 vs W-2 workers for employers and employees
- Specific Expertise
- Many employers need people who have specific expertise for unique projects. For example, hiring an outside management consultant is an independent contractor because that person is hired to solve a specific problem. Due to their high expertise, some contractors can charge high hourly rates and per project fees. This benefits the contractor as he or she can earn more by working less.
- Less Expensive
- Despite earning high hourly rates or project fees, they aren’t entitled to benefits nor reimbursements. Employers can benefit because they don’t have to pay for vacations nor expensive health care benefits. Employers don’t have to pay FICA taxes nor unemployment taxes (FUTA & SUTA) for contractors.
- More Freedom
- This can benefit both the freelancer and employer. Freelancers who earn high rates can earn more working less and have a better work-life balance. Employers don’t have to offer their contractors protections like overtime pay or workers compensation. Workers compensation gives injured employees a source of income while they recover at home. Workers compensation has many rules, which can be explained here.
Cons of 1099 vs W-2 assistance for employers and contractors
- No Stability
- This can be a disadvantage to both contractors and employers. Contractors can work when they want and have little supervision. This could be tough for an employer who wants tasks completed a certain way. Contract workers have more freedom, but their projects can be terminated with short notice. Thus, most freelancers are always prospecting for new clients.
- Weaker Relationships
- Contractors don’t build a strong type of relationship with an employer like an employee does. They usually work off-site or come into the office infrequently. It’s also rare to find contractors participating in employee bonding events like holiday parties. Contractors can become lonely at times, compared to employees.
- Mislabeling Risk
- Sometimes, companies can intentionally mislabel 1099 vs W2 workers in order to not pay employee benefits. Not paying employee benefits might save money short term, but it costs more over the long run. For example, misclassified employees don’t access entitled benefits, which hurts morale and productivity. Mislabeling is illegal and is punishable by IRS levied fines and even jail time for guilty businesses.
Best industries for 1099 contractors
Some of the best industries for freelancers include seasonal industries like summer swim lessons and retail. Usually, businesses that have temporary booms and busts can benefit from contractors. Another example includes an accounting firm hiring freelance tax preparers for only tax season. The business can end the contracts once the busy cycle is complete, which allows it to save money. If these tax preparers were employees, the business would waste money by having them sit in an office and not work.
The rise of the internet has contributed to a digital freelance economy. Many businesses that need online services like data entry, writing, design, and coding can hire contractors from foreign countries. They can use sites like Fiverr and Upwork to do this. Some businesses hire cheaper contractors from developing nations like India and Pakistan. This could be helpful, but it’s important to be aware of the freelancer’s work quality as well as price.
There are many different employment statuses, but the main two boil down to 1099 vs W2. Employees are called W2ers based on form W-2, while contractors are nicknamed 1099ers after form 1099. Both scenarios have their own unique pros and cons for employers as well as individuals.
More free-spirited individuals might prefer a 1099 lifestyle, while those looking for stability crave the structure spirit W2 employment. In fact, 43% of the workforce will be freelancers in 2020 per Nasdaq, which gives a unique insight into the future of work. This post also covered case studies to help businesses along individuals decide between 1099 vs W2 work and which is better for them.
Disclaimer: This article is not tax advice and is used for only educational purposes. Consult a CPA or tax adviser for tax advice.