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Managing human resources is one of the most challenging aspects of owning a small business. Beyond handling onboarding, employee relationships, and other vital tasks that would fall into a dedicated HR manager’s lap, you also need to account for staffing costs—which usually makes up the largest percentage of a small business’s expenses. Because of this expense, many small business owners need to consider whether to hire a 1099 vs. W2 employee for certain positions.
There are a few major differences between these two types of workers, and classifying them properly with the IRS is absolutely crucial. So, what are those differences, and when is it best to hire 1099 vs. W2 employees? What are the potential pitfalls of outsourcing a 1099 worker as compared to hiring an employee outright?
These questions have significant implications for your small business (and, of course, it’ll impact your business budget), so we’ll help you find the answers. First, we’ll explore the pros and cons of hiring contractors whose payments are reported on a 1099 form vs. W2 forms. Then, we’ll take a look at a few solutions that combine the best of both options.
Let’s start by taking a look at the differences between a 1099 vs. W2 employee. Both are named after their respective tax forms: Independent contractors are responsible for filing Form 1099-MISC, and employers file Form W2 for their employees.
Although both independent contractors and employees provide vital services to the small businesses they work for, there are several important differences between the two. Understanding these differences is vital—if an employee is misclassified as an independent contractor, you could be subject to costly fines and legal fees. And W2 workers who are misclassified as independent contractors are denied the benefits they’d otherwise be owed, including health care and the minimum wage.
To cut down on the confusion, we’ll go through the key identifiers for both types of workers, and how you can discern their appropriate classifications.
A 1099 worker—or independent contractor—generally provides specific services, as defined by a written contract. Some 1099 workers only work on one project at a time, but many serve multiple businesses providing a service within their expertise. In short, independent contractors are self-employed, so they’re business owners themselves.
By extension, that means 1099 workers pay both employee and employer taxes—so, if you choose to hire an independent contractor, your business doesn’t need to cover those expenses. And, as their own business owners, 1099 workers aren’t eligible for the benefits you offer your W2 employees.
As is the case in your own business, independent contractors define for themselves how and where they work, and what tools and methods they use to complete the work you hired them for. 1099 workers can also choose to hire their own workers to help them carry out the product or service that you hired them to provide. So, independent contractors assume the risk for their own profit or loss when they carry out their job.
Finally, there’s another key difference between 1099 vs. W2 employees: Most of the time, businesses hire employees with the intention of working with them for an undetermined length of time. On the other hand, businesses engage independent contractors for a defined period of time, as per the conditions outlined in the contract. But that engagement may be renewed as many times as both the 1099 worker and the business owner find it to be mutually beneficial.
A W2 employee is essentially what you’d think of as a typical, salaried employee. Of course, W2 workers don’t enjoy many of the benefits of an independent contractor—most obviously, W2 employees don’t get to define their own schedules.
However, there are a number of perks to being an employee. Among these perks are:
We noted the importance of correctly classifying your employees as 1099 or W2 workers with the IRS. Often, cost and the intricacies of human resources are the key determining factors a business owner considers before choosing whether to engage a contractor or hire an employee. To be fair, it’s much easier to pay a contractor than it is to administer payroll and handle other HR functions required of a business with employees.
But any cost and time savings quickly disappears if workers are reclassified during a labor audit.
Admittedly, the line between 1099 and W2 workers may become a little blurry—but it’s not entirely at your discretion to determine whether your hires are 1099 or W2 workers. The IRS considers three major categories in determining whether workers are employees or independent contractors:
According to the IRS, what the employee classification process really boils down to is the level of control a business has over the worker, and, by extension, the amount of independence the worker has. If there is less of the former, and more of the latter, then the worker is most likely a 1099 worker. If the opposite is true, they’re most likely a W2 employee.
But if you’re still unsure whether a member of your staff is a 1099 vs. W2 employee, either you or your employees can file a Form SS-8. In that case, the IRS will make a determination for you about how you should classify your employees.
Now that we know the difference between an independent contractor and a W2 employee, it’s time to answer the question you’ve probably been asking yourself: “Which type of worker is better for my business?” As is usually the case, the answer is: “It depends.”
Many small business owners choose to work with independent contractors because of the perceived cost savings. Employment taxes, workers compensation insurance, overhead costs like office space and break-room supplies—they’re all necessary expenses when you hire W2 employees, and they can quickly erode a business’s bottom line.
In addition to the costs, though, you’ll also need to weigh the benefits of each option. Although their services might be more expensive than those of an employee, an independent contractor’s expertise can often yield a higher-quality product, and in less time than it would take an employee to complete the same work. But when you work with an independent contractor, you relinquish control over how and when they do their work. For some small business owners, that’s a no-go.
There’s a lot to consider when you’re choosing between hiring 1099 vs. W2 employees. To help you out, consult the following table. This highlights some of the scenarios in which you might choose an independent contractor over an employee, or vice versa:
As you can see, sometimes it makes more sense to engage the services of an independent contractor than it does to hire an employee. At other times, though, you’ll need to hire an employee to make sure your business runs properly.
If you’re still not sure which type of employee you should hire, there are some solutions at your disposal. These solutions allow business owners to enjoy the benefits of having employees, minus the administrative hassles.
If you’re not ready to decide whether to hire a 1099 or a W2 employee, you have two options to buy yourself some time: You can work with a temporary agency, or work with a professional employer organization. Both of these options allow you access to a pool of qualified workers, but you won’t need to worry about classifying them as either 1099s or W2 employees.
Is your business seasonal? Do you want to “test drive” an employee before hiring them on a full-time basis? In either case, you can consider using the services of a temp agency.
When you contract with a temp agency, the agency takes care of background checks, pre-employment testing, and timely payroll processing and tax payments. The temp agency also invoices your business for the employee’s wages, taxes, and a service charge for the administrative services the agency provides. This invoice is recorded as a simple business expense in your books, and you don’t have to worry about tax filings, workers compensation insurance, or many other human resources issues.
This option costs more than administering your own seasonal or temp-to-hire workforce, but the time savings could well offset the additional cost.
Of course, temporary agencies are a temporary solution to short-term employment challenges.
There is, however, a longer term solution unknown to many small business owners. A PEO—or professional employer organization—lets businesses outsource management tasks like payroll, workers compensation, and benefits, while retaining control of the employee’s day-to-day responsibilities.
In addition to relieving small business owners of the administrative burdens associated with managing employees, PEOs can also leverage the number of employees they manage to get better benefits options than small businesses alone can negotiate. As is the case with temporary agencies, PEOs charge a fee for their services, but the benefits may outweigh the costs.
Whether you choose to use a temporary agency or engage the services of a PEO, it’s imperative that you do your due diligence. Ask the temporary agency or PEO for references, and follow up with other business owners who have used their services.
And, as is always the case when you enter into a business contract, you should also engage an attorney to review any agreement with a temporary agency or PEO before you sign. This ensures that you’re not inadvertently taking on liabilities that the temp agency or PEO should be covering.
One of the most important tasks you’ll undertake as a small business owner is staffing your organization with the best possible workers. The question, though, is which kind of worker you should hire. Here’s a quick refresher.
1099 workers, or independent contractors, are self-employed. As such, you can hire 1099 workers for certain projects, but you can’t control when or how they complete their jobs. However, you’re not responsible for covering their Medicare and Social Security taxes, and you won’t provide them with the same benefits as you would for a W2 worker. That may be the less expensive option.
W2 workers, on the other hand, do require a regular salary, certain benefits, and more intensive management. So, the financial and energetic costs of hiring W2 employees may be higher than 1099 workers. But you might prefer to have a steady team of employees on hand, whom you’ve trained and can manage according to your standards.
In all, you’ll need to carefully weigh a few considerations before making your decision, including the type of work you need completed, how quickly you need that job done, whether the job is a one-time or regular commitment, and the costs attendant to hiring 1099 vs. W2 workers.
If in doubt, consider consulting with your accountant or an employment attorney before making your final decision about how to manage the workforce for your business.