1099 vs. W-2: What's the Difference and Why It Matters

One of the most common — and costly — mistakes small business owners make is misclassifying employees as independent contractors. The IRS takes this seriously, and the penalties can be severe. Here's what you need to know.

W-2 Employee:

• Works under your direction and control
• You set their schedule, provide tools, and direct how work is done
• You withhold and pay payroll taxes (Social Security, Medicare, federal and state income tax)
• You may provide benefits
• You issue a W-2 at year-end

1099 Contractor:

• Works independently, controls how they complete the work
• Sets their own schedule, uses their own tools
• Responsible for their own taxes (self-employment tax)
• No benefits required
• You issue a 1099-NEC if you paid them $600 or more in a year

The IRS uses a multi-factor test to determine worker classification, focusing on three categories:

1. Behavioral control — Do you control how the worker does their job?
2. Financial control — Do you control the business aspects of the worker's job?
3. Type of relationship — Is there a written contract? Are there employee-type benefits?

No single factor is determinative — it's the totality of the relationship.

If the IRS determines you've misclassified an employee as a contractor, you could owe:

• Back payroll taxes (both employer and employee portions)
• Penalties and interest
• Back benefits
• State penalties

The IRS has a voluntary correction program (Section 530 relief) for some situations, but it's far better to get it right from the start.

If you're unsure how to classify a worker, you can file Form SS-8 to ask the IRS for a determination. Or consult a tax professional before you hire.

Need help with worker classification or payroll compliance? The Gap ProAdvisors handles payroll and tax preparation for small businesses. Contact us.