If you’re managing your small business’ HR and payroll, you might struggle from time to time, especially if you’re not a human resources professional (which you likely aren’t). From hiring new workers to filing taxes, there’s a lot that goes into the HR role, and you have other responsibilities pulling you in a million other directions.

One question many entrepreneurs have as employers is whether to hire a full-time employee or a contractor. There are benefits (and drawbacks) to each you need to understand so you can make the best hiring decision for your business.

The Difference Between a 1099 and W-2 Employee

Hiring a W-2 employee, you are responsible for paying that individual’s wage as well as employee benefits like health insurance. You pay payroll taxes with each paycheck you issue, covering things like social security and unemployment insurance. A 1099 worker, on the other hand, may be temporary or project-based. That individual is responsible for paying her own taxes.

As an employer, you have to decide which is a better fit for a specific role: employee vs. contractor. There are specific situations where one is more ideal than the other, and we’ll get into those in this article.

1099 vs. W-2 and the Paycheck Protection Program

If you’re one of the thousands of small business owners who applied for and received funds from the Paycheck Protection Program, you probably know that you may be eligible to have all or a portion of those funds forgiven if you meet certain criteria.

As long as you maintained your number of workers during the eight-week period the loan covers, and used at least 75% of those funds on payroll, you may be eligible for loan forgiveness for that amount. However, this only applies to employees, not 1099 independent contractors.

You only qualify for loan forgiveness to cover payroll for full-time and part-time employees. Because independent contractors can apply for PPP for self-employed workers, they don’t qualify for you to cover with your loan.

Know that independent contractor misclassification—that is, including 1099 contractors in your payroll numbers to qualify for more Paycheck Protection Program funds—may keep you from being approved for a PPP loan, or from getting your full amount forgiven, so make sure you properly classify your employees and contractors. The government may look at applications and penalize businesses that misclassified workers.

The SBA has released its PPP loan forgiveness form, and among other information you’ll need to provide, you will be asked how many employees you had when you applied for the loan and how many you have upon requesting forgiveness. You’ll also need to provide payroll and nonpayroll costs (rent, mortgage, utilities). What you pay for contractors does not figure into either of these categories and therefore won’t be part of the forgivable amount.

Besides the PPP there are other loans for small business you may qualify for. Check your business credit scores to see what options you have.

W-2 Employee vs. 1099 Independent Contractor: What’s the Difference?

There are a couple of differences to consider between 1099 contractors and employees. The first is how you pay them. With an employee, you pay a regular salary and cover payroll tax and your portion of employee benefits. You take deductions out of the paycheck for health insurance, HSA, and 401(k) contributions if employees qualify for those benefits. 

When you hire an employee, you have them fill out a W-4 form. When you file your income tax for your company, you send each employee a W-2 form so they can report their earnings on their own taxes.

Contractors are hired at-will, meaning you can end a relationship at any time, adhering, of course, to the terms of your agreed-upon contract. If you want to fire a salaried employee, you’ll need to check your state’s employment law on requirements to do so, as you need a reasonable cause.

What is a W-2 Employee? 

A W-2 or salaried employee is a worker who works a set amount of hours of work each week, and, if she qualifies, receives employee benefits like health insurance. As the employer, you are responsible for paying things like payroll tax, social security tax, workers’ compensation, Medicare tax, and unemployment tax on each worker.

You may also opt to provide additional benefits, such as 401k matching or stock options. This is a great perk to attract top talent.

What is a 1099 Independent Contractor?

A 1099 contractor agrees to provide a specific set of services to a company and is not an employee. Your business categorizes payment to the contractor as a business expense, not payroll, and the contract worker pays her own taxes based on the taxable income provided on the IRS form 1099 you send her at tax time.

Who Qualifies As An Independent Contractor?

If you’re not sure whether to use employee classification as an independent contractor, the IRS’ definition should help:

“The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done. The earnings of a person who is working as an independent contractor are subject to Self-Employment Tax.”

So, to clarify: if you, let’s say, need a website created, the person you hire outside of your company is assigned that task. You can’t control how many hours a week he works on your project, nor what hours he works. You can give feedback and request edits on the final project.

If, on the other hand, you task an employee to create a website, you could mandate that they work on it 40 hours a week over the next two weeks. By this definition, the difference between a contractor and an employee is the amount of control you have over their work.

Misclassification of Independent Contractors

It’s important to be clear on how to classify an individual at your company because employee misclassification can have serious consequences. From the employee’s perspective, worker misclassification can mean they miss out on employee benefits they’re actually entitled to.

From your perspective as the employer, misclassifying an employee could result in a lawsuit, or if you are audited by the IRS, severe penalties and fines. That’s why it’s so important to properly classify them.

Can an Employee Be Both W-2 and 1099?

When it comes to 1099 vs W-2, typically, you will issue just one of these forms to an individual. The exception comes if you had a contractor who later came on as a full-time employee. In that case, the tax year this occurred, you would issue both a 1099 form and a W-2.

But generally, an individual will be one or the other. The IRS may raise an eyebrow if you file both for the same person.

Handling Taxes for 1099 Contractors vs. W-2 Employees

Unlike with W-2 employees, you don’t have to worry about paying payroll tax or benefits for an independent worker. When you bring on an independent contractor, if you expect to pay them $600 or more in a year, you have them fill out a W-9 tax form, and at tax time, you will need to issue 1099 tax forms when filing your tax return so any contractors can claim the revenue from working with you and pay taxes on the taxable income. 

If you pay them less than $600 a year, you would just categorize that as a business expense; no tax form needed.

With an employee, you’ll set up their tax deductions and tax withholding in the employee’s paycheck when you first hire them. If they are eligible for employee benefits, you’ll also calculate any applicable tax deductions as part of their employee compensation.

Employee vs. Independent Contractor: Which is Better for Your Business?

So when it comes to hiring an independent contractor vs. employee, which makes better sense? The answer is: it depends on your business needs and how you want to pay the worker.

Advantages of W-2 Employees

If you plan to hire a permanent position, you need to make the offer compelling enough to attract top talent. Professionals look for full-time roles with employer-sponsored health insurance and other employee benefits. In exchange, you’ll take on paying employment tax and those benefits. 

Hiring a regular employee over a contractor tends to get you more long-term commitment because employees are more likely to stay for a secure salary and benefits than a contractor would for piecemeal work. They are more invested in company culture and more likely to work hard for you for years.

Know that hiring an employee will cost you far more than just her salary. Those employment taxes and employee benefits can add up, as can productivity lost due to sick days and vacations.

Right now, it’s advantageous to have W-2 workers if you’re planning to take out a PPP loan since your payroll numbers factor into how much you can borrow and have forgiven.

Advantages of 1099 Independent Contractors

If you need part-time help or temporary assistance on a finite project, contracting might be a better worker classification. Many companies who need help with web design or marketing hire contractors because they don’t foresee needing the same amount of work indefinitely. Some companies do keep on independent contractors long-term because the overall cost, even if they are paying a higher hourly rate than they do for full-time workers, ends up being lower.

Sometimes you have a project that requires a skillset outside of what your current staff possesses. That’s a great opportunity to bring on a 1099 worker. And if you don’t have time to micromanage the work they do, most are competent at working independently and getting the job done with minimal supervision.

Some businesses start out hiring 1099 contractors and then, if the work is sufficient, offer that individual a full-time employment position. This gives you the chance to test out that person’s skills to see if she’s a good fit for your company before investing in a full-time salary.

Another benefit is that you aren’t required to pay for workers’ compensation for independent contractors, typically.

On the downside, contractors often work with multiple clients, so you might not get the work done as quickly as you would if it was performed by a full-time employee. And the contractor might not be as connected to your company culture as an employee would be.

Pros and Cons of 1099 and W-2 from an Employee’s Perspective

So which would an individual prefer: independent contractor status or employment status? It depends. Many prefer the stability of a steady paycheck, employee benefits, and stock options. Others like working when and with whom they choose. Explore both possibilities the next time you need to hire to maximize your pool to hire from.

Nav’s Final Word:  W-2 vs. 1099

As a small business owner, you have to weigh hiring a 1099 worker vs. W-2 employee based on your employment needs, budget, and tax situation. There may be instances where having a full-time employee makes sense, but you may also bring on a contractor short-term to help out.

If you’re still not clear on how either employment statuses will impact your state or federal income tax filing, seek tax advice from a CPA or bookkeeper.