1099 vs. W2 : Which is Better?
November 8, 2015
November 8, 2015
Do tax rules confuse you? Wondering whether you are a 1099 contractor or a W2 employee? This is an important distinction for federal tax purposes.
Worker classification is done to differentiate between how you pay taxes and how you file returns. Whether you come under 1099 or W2 classification, this will affect your qualification for employer benefits, social security and Medicare benefits, and tax responsibilities.
If you are confused about your work status, this post can help you differentiate between 1099 and W-9 to establish your classification as a worker.
What is Your Work Status?
Whether you are an employee or an independent contractor, it all depends on financial control, behavioral control, and relationship between parties, as defined by the IRS.
When a business has the right to give directions & extensive instructions and control the work process, in that case, a worker is an employee. On the other hand, if you receive less extensive instructions as to what needs to be done, you may be classified as an independent contractor.
Additionally, self employed persons hardly receive training about the work procedures and methods, as opposed to an employee, who may get training from the employer to guarantee that the work is done in a specific way.
Employees do not make any investment to do work for the employer. Contrarily, an independent professional may require a significant investment in their work, though this is not a compulsion. If an employee makes an investment or business expenses, the employer is responsible to reimburse them. On the other hand, you may be an independent contractor if you are not reimbursed for the business expenses.
Relationship Between Parties
If you receive employee benefits, including paid leave, pension, and insurance, this is an indication that you share an employer-employee relationship. On the other hand, if you do not receive any such benefits, you could be an independent contractor. Ideally there is a continuing relationship between an employee and employer, though an independent contractor and a client may continue to work long time, without any contractual agreement.
Are You an Independent Contractor?
A self-employed person is also known as a sole proprietor, independent contractor, freelancer, free agent, and subcontractor. In simple tax parlance, in order to be eligible for an independent contractor for taxation purpose, you must be able to show that you work as a self-employed person engaged in a business.
There is an increasing trend in the job market to move more and more toward independent contractors instead of hiring permanent employees on a payroll. But this has given rise to the confusion whether contractors are classified under 1099 or W-2 category. Well, independent contractors are always classified under IRS 1099 forms, whereas W-2 category is used for full-time employees. In simple words, an independent contractor is eligible to get a 1099 form, whereas a full-time employee gets an IRS W-2 form.
As an independent contractor, you are your own boss and
- Set your own schedule
- Work as per your own desire
- Use your own equipment to work
- Choose to work on projects as per your desire
- Can turn down work offers as you wish
- Work with more than one client
On the other hand, if you’re an employee, you
- Work for and under someone else
- Have a set work schedule
- Are on a work schedule
- Are provided the necessary tools and materials for the task
There is a clear dividing line between self-employed workers and employees. Both are classified under different tax categories – 1099 and W-2.
Since independent contractors do not work under any employer, it is solely their responsibility to calculate and pay payroll taxes to the government on a quarterly basis. On the other hand, in the case of a W-2 employee, there is automatic deduction of payroll taxes from their paycheck by the employer.
Ideally 1099 employees are hired on a temporary basis or on contract to work on a specific project. Under work for hire contracts, independent contractors may be hired to provide temporary support in the absence of a W-2’d employee.
IRS Form 1099 Vs. W-2
Independent contractors get a flat fee per project and not a fixed or hourly salary, unlike full-time employees. As a self-employed professional, you are required to annually submit a 1099 form.
W-2 form documents the income, wages, commissions, and tips earned by employee. The earnings statement also includes the total amount of taxes, including social security, state, and federal, withheld by the employer throughout the year.
Contrarily, the 1099 form details the total amount of income or pay earned by freelance or temporary employees in a given year, without any social security, federal, or state taxes withheld at the time of payment. However, this income also includes dividends and interest earned.
The federal government expects independent contractors to pay appropriate taxes calculated on the basis of fee schedule established by the state tax commission and Internal Revenue Service (IRS) annually.
Contractors are eligible to deduct work-related expenses, including supplies or any other materials associated with work. However, the 1099 form must include all other sources of a contractor’s income, including royalties or prize money.
Thus as a self-employed professional, you can avail certain tax benefits that a W-2 employee cannot. While a 1099 professional takes home the net income, W-2 people receive take-home pay, which is less than their gross wages, because of the employer withholding social security and taxes. Tax of an independent contractor is calculated on net income.
On the other hand, a freelancer or independent contractor pays twice the social security and Medicare taxes compared to an employee, because the employer is responsible for paying half of the Medicare and 12.4% social security tax for the latter. In the case of the self-employed professional, the client doesn’t report withholding of income taxes, nor do they deduct Social Security/Medicare while making them payments.
In the case of 1099, unemployment and workers’ compensation must be addressed independently. As a 1099 earner, you are responsible to make quarterly estimated tax payments, especially if you owe over $1,000 at tax time. As opposed to salaried employees whose employer withholds taxes at each paycheck, you make payments four times a year.
Self Employment Tax Deduction
As an independent contractor, you need to pay a tax of 15.3 percent on your net income if you earn over $400. This is almost double the amount of tax that W2 form people need to pay. Another difference between 1099 and W-9 is that self-employed people are eligible to deduct half of the self-employment tax paid from their income. This tends to lower their overall tax liability. All self-employed persons are responsible for paying Self-Employment Contributions Act – SECA.
In the eyes of the IRS, a self-employed person is technically a small business, which makes you eligible to subtract business-related expenditure under Schedule C. The expenses may include the cost of professional services, like hiring an accountant for tax calculations, insurance premiums for business, and transportation expenses on business.
As an independent contractor, you will receive Form 1099- MISC (Miscellaneous Income) to report your income. To make estimated tax payments for the year, sole proprietorships may deduct business expenses on Schedule C of income tax return. Independent contractors are required to file a schedule C with tax return and receive a 1099 form for all incomes in excess of $600. All business expenses of an independent contractor are itemized on Schedule C. The expenses are then filed with the personal income tax return.
An incorporated contractor is a W-2 employee of the corporation and files a personal income tax return.
An increasing number of companies are interested to use independent contractors to save on their share of the tax payments, social security, workers or unemployment compensation. More and more people are choosing to become sole proprietors, given the benefits of working independently and the easy availability of gigs in on-demand marketplaces, such as Peer Hustle.
It is becoming increasingly important for employees, employers, and independent contractors to understand the clearly laid out IRS rules in determining the work classifications. Get the work classification correct upfront to avoid the hazards of misclassifications and save yourself on penalties later. This could even lead to jail time.
It is important for employees to know whether they are true employees or independent contractors so that they do not lose out on the benefits.
Whether to choose 1099 vs. W2 is a crucial decision that will impact your work status and ability to accept certain benefits, insurance, and assignments, besides affecting your tax liabilities. It is not simply a matter of choice, but a step further, which can have legal implications.
It is important to make the right choice and understand the IRS guidelines clearly so that you enjoy your dream career and get all the benefits you had expected.