W2 or 1099 — Does It Really Matter?

Do you own a small business and pay workers to perform services for you? If so, are you wondering whether it matters whether you give them a W-2 or a 1099-MISC? Read on to find out.

The short answer to this question is simple: It matters a lot. And there’s a lot at stake here, so do not take this issue lightly.

The question of what tax reporting form to give your workers is just the tip of the iceberg of a huge issue known as “employee vs. independent contractor.” If your workers are employees, they should receive a Form W-2. If they are independent contractors, they should receive a Form 1099-MISC.

Why does it matter? It matters because if you’ve been paying your workers as employees, you should have been issuing paychecks and withholding income taxes (federal and state) as well as payroll taxes (Social Security and Medicare tax) from those paychecks. You should have also been paying these taxes to the appropriate government agencies over the course of the year. Depending on the amount of withholdings, you can be required to make payments weekly, monthly or quarterly. In addition, if you have employees you should also be calculating and paying federal and state unemployment tax, which can also be due every quarter.

If your workers are independent contractors instead of employees, then you don’t withhold taxes and you don’t make the above-mentioned payroll tax payments. Instead, you simply pay the agreed-upon amount to the contractor, and he/she is responsible for any federal and/or state taxes due on that income.

There’s also a lot at stake in terms of your expenses. If you pay your workers as employees, you must also pay your share of payroll taxes (Social Security, Medicare and unemployment taxes). If your workers are paid as contractors, you do not incur any payroll tax liability. There is also much more paperwork and administrative expense involved with employee compensation. There’s much more number-crunching, and you must make numerous payroll tax payments on time or be subject to late payment penalties and interest.

So it is obviously to your advantage to make payments to contractors instead of employees. Unfortunately, however, you cannot decide how to treat your workers based on your expenses. In fact, that should not be a deciding factor at all. The IRS frowns upon businesses that treat workers as contractors simply to save money. Instead, you must determine the true classification of a worker apart from expense considerations, and if you’re unsure how to do that, give me a call or send me an email and I’d be glad to help you sort this out.

If you’d like to read up on this issue, here’s a good resource to get you started: