by Clint Blundon

Payroll Vault

Knowing how to classify contractors and employees is very important, especially for small businesses.  What are the main differentiators?


A 1099 is issued to independent contractors to report the payments a company makes to the contractor, and to inform the IRS the payments have been made.  It’s then incumbent on the contractor to report and pay taxes, independent of the company issuing the 1099, as the 1099 recipient/contractor is considered self-employed.   A W-2 is issued to hourly and/or salaried employees to report their income and payroll taxes withheld.

How does the IRS classify workers?  According to the IRS, an employee is anyone who performs a service or services for you (or your company), and you control the scope of the work required and how it will be done.  If an employee requires little assistance due to their skills and experience, and if their schedule, work and performance is directed and managed by an assigned manager for example, that person is most likely an employee.

Conversely, an independent contractor is defined as anyone who offers their services to other businesses or to the general public. If the company paying for services only has the right to control or direct the result of the work and not what will be done, or how it will be done, that generally defines them as an independent contractor.

Fairly straightforward, right?  Sort of; however, defining the difference between employees and contractors can get a bit complicated at times.  Keep in mind that there isn’t one single factor defines whether a worker is an employee or contractor, so it is important to look at each worker and evaluate the circumstances on a case-by-case basis. Consider the entire scope of the relationship.  Carefully examine the degree or extent of the right to control and direct the worker’s activities. These factors will help you determine the difference between a W-2 employee and a 1099 contractor.

Accurately keeping track of and classifying employees and contractors is critical – not only to keep payroll running smoothly, but to stay in compliance with federal, state, and local tax laws.  How a worker is classified directly impacts how employer taxes are paid, and how your employees are equipped to pay their Federal Income Tax, Social Security Tax, and Medicare tax.

Other examples to consider…  If the worker receives detailed training and/or instruction on how the work is to be completed, that person may be a W-2 employee. Instructions could include when and where to work, what tools or equipment to use, what order or sequence to follow when performing the work.

If a worker receives less detailed training or instruction, that person may be a 1099 contractor. Time and place could be less important than how the actual work is performed. The amount of instruction may also vary depending on the type of work performed; however, if the employer gives little to no instruction, but acts in a manner that exhibits authority over the work performed, behavioral control could apply if the employer has contractual right to control the individual results.


Quality benefits attract and retain high performers, and they can increase morale. W-2 employees may receive benefits, such as health insurance, paid vacation, sick pay expense reimbursement and so on.  W-2 employees are typically with a business for an indefinite period – not on a per-project basis.  Employees benefit from job security as well, and employers receive value by having consistent pool of workers.

If an employer needs to have tasks completed in a specific way, hiring employees is likely the best approach.  It can be better for the worker too, as many employees prefer stability and a predictable schedule and compensation plan.


A 1099 is used to record many items; however, the 1099-MISC records contractor’s earnings.  Employers use Form 1099-MISC to report to the IRS and contractor how much they paid the contractor. This form contains critical information like a contractor’s tax identification number, withheld taxes and the payor’s information.

The 1099-MISC is filed when a business paid a contractor at least $600 in gross payments. Independent contractors are also referred to as freelancers or consultants, and they’re considered self-employed by the IRS.  Some contractors refer to themselves as small businesses since they’re self-employed.

What are the downsides of hiring contractors vs. employing workers?  Contractors can work when they want and have little or no supervision. This will likely be tough for an employer who wants tasks completed a certain way. By the very nature and definition of being a contract worker, they have more freedom; however, their projects can typically be terminated on short notice. Thus, many contractors are constantly looking for new clients and new business.

What happens when companies accidentally or even intentionally mislabel W-2 and 1099 workers to avoid employer reporting requirements or paying employee benefits? Not paying employee benefits could save money, but it will likely cost more over the long run if or when a problem arises.  One example is misclassified employees don’t have access to benefits they may be entitled to, which can hurt morale and productivity. Intentionally mislabeling a 1099 contractor who meets all the criteria of a W-2 employee can be illegal and may be punishable by IRS in the way of levied fines and possibly even jail time for the offenders.  Don’t play this game.


Between daily operations and the unpredictable nature of business ownership, it can be difficult to manage payroll without the assistance of qualified experts. Payroll Vault is ready to help guide small businesses through these tricky situations, and help keep them in compliance current tax laws.  We pride ourselves on being industry leaders who prioritize efficiency and service, and we are ready to help. Reach out today for a free consultation.