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 financial penalties or lawsuits due to misclassified workers.
This article will explain what a 1099 employee is, how they differ from traditional W-2 employees, and what rules you need to know when hiring a contractor.
A 1099 employee is an independent contractor. The name derives from the Internal Revenue Service's (IRS) Form 1099, which 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 employment agreement, or 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.
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 types of 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 workers with the necessary tools and supplies for them to do their jobs. They are also eligible for traditional employee benefits and other perks, like health insurance and retirement plans.
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 taxes.
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:
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 status1.
On January 10, 2024, the U.S. Department of Labor published a new final rule on classifying workers as employees or independent contractors2. These new rules go into effect on March 11, 2024, replacing the 2021 IC Rule.
One of the new rules is the implementation of the economic dependence inquiry. If workers are dependent on a particular employer for continued employment, though not necessarily income, they are likely an employee. But, if the individual replies more on their own work, such as from their own freelance business, they're an independent contractor.
The rules also reinstated an economic reality test.
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 project-based work 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 key aspect of why organizations hire contractors is that companies 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.
There are many reasons someone chooses to become a contract employee, including:
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.
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. The payment method can be any way you pay for W-2 employees, like check, direct deposit, paycard, or your company's payroll.
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 benefits, or business expenses.
You report the earnings of your contractors with Tax Form 1099-NEC3 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-MISC4 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.
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This blog post was originally published on October 19, 2022. It was last updated on January 18, 2024.
3. https://www.irs.gov/forms-pubs/about-form-1099-nec
4. https://www.irs.gov/forms-pubs/about-form-1099-misc