It is no secret that the modern economy has changed the employment relationship between workers and companies. Many companies have responded to cost pressures by changing how they employ labor to reduce personnel expenses and control costs.
As a result, many companies are now hiring independent contractors with strong personal brands for specific, low-key tasks and projects instead of finding more expensive full-time employees.
Without knowing about this evolution of the labor market, the difference between contractors and employees can pose a challenge.
To understand the nuances between employees and contractors from a tax perspective (e.g., 1099 vs. W-2, payroll tax, etc.) and costs (e.g., compensation and benefits), as well as other material differences (e.g., company control); this post will look at the differences between these two business relationships.
What is a Form W-2?
A W-2 form lists the number of year-end wages, taxes withheld, and payment information needed to file federal and state income tax returns. The form includes a lot of information, including payroll deductions, pre tax benefits (e.g., 401k contributions, HSA contributions), and more.
An employer must send this form to the IRS and provide copies to the employee to file a tax return.
What is a Form 1099?
Form 1099 is available in several variations. For this publication, it will serve as proof that an entity or person, and not your employer, paid you money. The law requires that any payment for services over $600 be filed on Form 1099 with you and the IRS.
Freelancers, independent contractors, or other workers in the informal economy receive 1099 forms from their clients. These documents reflect the money that the client has paid to the worker.
The forms include your social security number or tax ID number, which means the IRS will know you have the money. You must report this income on your annual tax return.
However, simply receiving a Form 1099 does not indicate that you will have to pay taxes if you take advantage of tax-saving opportunities. If you're looking for other tax avoidance opportunities, talk to a tax professional.
1099 vs. W-2: What is the tax difference?
Due to the ever-changing demands of the workplace, many people need to work more independently and have multiple jobs or areas of work to progress.
Some do it by choice because it gives them the freedom to pursue what they want most and the flexibility in their daily lives.
These qualities are synonymous with financial independence and can be an added advantage.
On the other hand, others work as independent contractors to survive until they can find a more permanent job with better pay and benefits. Until then, working as an independent contractor might be a suitable alternative.
From a tax viewpoint, the two receive separate tax forms when balancing the differences between 1099 contractors and W-2 employees. Independent contractors receive a 1099 form, while employees receive a W-2 form.
As a contractor, Form 1099 shows the total compensation received by that business but makes you responsible for calculating and paying quarterly wages and income tax.
As an employee, your employer withholds these income and payroll taxes on your behalf and remits them directly to the government.
An independent contractor pays not only employee contributions (6.2% for social security and 1.45% for health insurance) but also company contributions.
Since you are considered an employer when working as an independent contractor, this translates to a total payroll tax payment of 15.3% of your earnings.
However, you can claim a self-employment tax deduction on half of these taxes, thereby reducing your tax liability.
While this still leaves you in the hole compared to an employee who only pays half, one advantage that the self-employed have, especially after the 2018 tax reform, is the possibility of deducting expenses related to your work.
Your laptop, table, and chair you just bought for your home office are all deductible (you can even deduct expenses associated with having a home office!). Employees no longer have the same luxury.
How to get help with taxes and other financial needs
If you need help managing your tax planning, like claiming the correct deductions, making accurate quarterly tax payments, tracking your finances, and more, consider hiring a tax professional to help.
Keep more of what you earn by hiring an independent tax professional to make the right decisions for your situation.
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