W-2 Employees vs. 1099 Contractors: What’s the Difference?

If the IRS decides a contractor is really your employee, you’ll owe back payroll taxes, penalties, and interest. Plus, your state may add its own penalties. It happens more often than you might expect. The National Employment Law Project estimates that anywhere from 10% to 30% of employers misclassify employees as independent contractors.

The rules may seem complicated at first glance, but they follow a pattern you can use to test any worker. If you’re about to bring on help, set them up correctly from day one. If you already have a mixed team, review your earlier decisions and fix any that don’t hold up.

🌟 KEY TAKEAWAYS

If you control what a worker does and how, when, and where they do it, the IRS considers them an employee.

The IRS looks at how the work gets done, so a signed independent contractor agreement won’t help your case if the facts describe an employee.

The IRS’s Voluntary Classification Settlement Program can help you fix a misclassification before the IRS finds it.

What is a W-2 employee?

A W-2 employee works for you and is on your payroll. You have the right to direct their work, including what they do and generally how, when, and where they do it.

For example, say you own a bakery and hire a cashier. You set their schedule, they use your register, and they earn an hourly wage. That’s an employee.

Being on your payroll means you handle the taxes. Each pay period, you withhold federal (and sometimes state) income tax and the employee’s share of Social Security and Medicare taxes. You also pay a matching employer share of Social Security and Medicare taxes, plus federal and state unemployment tax. You send both the employee and employer share to the appropriate government agency.

Employee status offers several legal protections. Employees may qualify for minimum wage and overtime pay, unemployment benefits, and workers’ compensation if they get hurt on the job. If you offer benefits like health insurance or a retirement plan, your employees can enroll.

At year-end, you report each employee’s pay and withholding on Form W-2 and give the employee a copy they use to file their tax return.

What is a 1099 contractor?

A 1099 contractor, also known as an independent contractor, sells you a service. They typically decide how, when, and where they work and provide their own tools and equipment. They usually serve more than one client.

For example, say you hire a designer to create a new logo for your business. They do the work on their own timeline and use their own laptop and software. Then they send you an invoice. That’s an independent contractor.

You typically pay independent contractors from their invoices rather than through payroll. They may charge a flat project fee, an hourly rate, or a monthly retainer. Contractors handle their own taxes. They pay income and self-employment tax, usually through quarterly estimated payments. You don’t withhold or pay any taxes on their behalf.

At year-end, you report what you paid each contractor on Form 1099-NEC. For payments made in 2026, you must send a 1099-NEC to any independent contractors you paid $2,000 or more during the year. That threshold was $600 for 2025 and earlier. The deadline to send Form 1099-NEC to the worker is January 31 of the following year. It moves to the next business day if that deadline falls on a weekend or holiday.

You may come across the term “1099 employee” online, but that’s a misnomer. The “1099” refers to the tax form you use to report payments to independent contractors at year-end. A worker is either your employee or an independent contractor, and employees don’t receive a 1099.

W-2 vs. 1099 at a glance

How to tell if your worker is a W-2 employee or a 1099 contractor

The IRS decides whether someone is an employee or independent contractor with what it calls the common-law test. The test looks at three categories:

Behavioral control

Behavioral control looks at whether you have the right to control how, when, and where they work, even if you never exercise that right.

They’re an employee if you:

They’re a contractor if you:

For example, say you hire a part-time bookkeeper. She works in your office on Tuesdays and Thursdays, uses your software, and follows your month-end checklist. She’s likely an employee.

On the other hand, you might instead work with a bookkeeper who owns her own firm. She works from her office on her own schedule, uses her own software, and sends you finished reports by the 10th of each month. This is likely an independent contractor relationship.

Financial control

Financial control covers how you pay the worker, who covers expenses, and whether they can make or lose money.

They’re an employee if you:

They’re a contractor if you:

For example, say you hire a photographer to shoot your product images and social media content. You pay him $26 per hour biweekly, supply the camera and lighting, and reimburse his travel expenses. He works only for your business. He’s likely an employee.

On the other hand, say you hire someone to shoot product images. He charges a flat fee for the project, uses his own gear, and absorbs any extra costs if the shoot runs long. He also shoots for several other brands. He’s likely a contractor.

Type of relationship

This looks at how you and the worker view the arrangement and whether your day-to-day actions match the paperwork.

They’re an employee if you:

They’re a contractor if you:

For example, say you hire a graphic designer to handle your marketing materials. The role is open-ended, and she designs everything your business sends out. She gets paid time off and health insurance. She’s likely an employee.

On the other hand, say you hire a graphic designer to build your brand identity over eight weeks. She signs a project agreement, isn’t eligible for employee benefits, and her work with you ends when she delivers the final files. She’s likely a contractor.

Keep in mind that an independent contractor agreement alone isn’t enough to determine the type of working arrangement you have. The IRS looks at the whole relationship.

But the IRS isn’t the only party interested in how you classify employees. The Department of Labor (DOL) and many states also pay attention.

For minimum wage and overtime, the DOL uses an economic reality test that considers 6 factors:

Many states apply their own tests, and some are stricter than the federal ones. For example, California’s ABC test treats a worker as an employee unless you prove all of the following:

Check your state labor department’s rules or consult an attorney before relying on the IRS test alone.

Your worker classification checklist

Work through this checklist for each worker, one at a time. Answer yes or no to each. 

Behavioral control

Financial control

Type of relationship

How to read your answers: No single yes or no decides the outcome. The IRS weighs the whole relationship, so look for a pattern.

What does each type of worker cost you?

When you hire an employee, their salary or wages are only the starting point. As an employer, you also pay:

For example, say you hire a full-time employee who works 2,080 hours per year. Here’s what they’d cost if they earned $25 per hour:

That total doesn’t include state unemployment insurance, workers’ compensation, paid time off, or benefits, since those amounts vary by state and employer.

With an independent contractor, you usually agree on the rate upfront, so costs are more predictable. But a contractor’s rate usually runs higher than an employee’s hourly wage because the contractor has to cover their own taxes, insurance, and retirement savings. They also have to absorb unpaid time between jobs.

When should you hire a W-2 employee or a 1099 contractor?

When deciding whether to hire an employee or a contractor, start with the work rather than the budget. An employee may be a better fit if you need control and consistency, while a contractor usually fits short projects that require specialized skills that aren’t core to your business’s products or services.

Don’t classify a worker as an independent just to save money. Penalties can be harsh for businesses that treat an employee as a contractor without a reasonable basis.

What happens if you misclassify a worker?

Misclassifying a worker can be costly, and the bill grows each year and with each worker. The IRS can assess back taxes, penalties, and interest whether the mistake was honest or deliberate. You may also owe unpaid minimum wage and overtime on misclassified employees.

Back taxes

If the IRS decides a contractor was your employee, you owe the employment taxes you should have paid. That includes both the employer and employee share of FICA.

The IRS can reduce the penalty if the mistake was not intentional.

Penalties and interest

The IRS can add penalties and interest to the back taxes.

What to do if you think you got it wrong

If you’re worried you misclassified an employee as an independent contractor, you have two options for fixing it with the IRS. Addressing the issue proactively usually costs a fraction of what the IRS can assess if it finds the problem first.

Option 1: The Voluntary Classification Settlement Program (VCSP)

The VCSP lets you reclassify workers as employees going forward and offers partial relief from federal employment taxes. You pay 10% of the employment tax you would have owed on the most recent tax year’s pay. You won’t owe interest or penalties on the payment.

To qualify, all of the following must be true:

To apply, file Form 8952 at least 120 days before the date you want to start treating them as employees. Don’t send payment with the application. If the IRS approves your application, it will send you a closing agreement to sign and return with full payment.

Option 2: Form SS-8

You can file Form SS-8 to ask the IRS for an official ruling on the worker’s status. The IRS reviews the facts, but it can take at least 6 months to respond. A worker can also file one without telling you, and the IRS then contacts you for information.

An SS-8 request isn’t an audit, so it doesn’t stop you from applying for the VCSP.

How to pay each type of worker

Pay employees through payroll, and pay contractors from their invoices. Here’s the standard process for each one.

For employees, collect a Form W-4 for each new hire. Employees use this form to tell you how much income tax to withhold from their pay. Each pay period, withhold income tax and the employee’s share of FICA taxes, then deposit those taxes along with your employer's share. At year-end, report each employee’s pay and withholding on Form W-2.

For contractors, collect a Form W-9 before you issue the first payment. It gives you the contractor’s legal name and taxpayer ID, which you’ll need to send them a 1099. Track what you pay each contractor during the year. At year-end, send Form 1099-NEC to each contractor you paid $2,000 or more. Leave out payments made by credit card or payment app, since the processor reports those on Form 1099-K.

FreshBooks Payroll, powered by Gusto, lets you run payroll and pay contractors from the Payroll page in your FreshBooks account. It calculates, withholds, and files payroll taxes for each pay run for supported tax agencies and jurisdictions. Gusto reviews and approves your setup before your first pay run.

It’s available to U.S. businesses on a paid FreshBooks plan.

Make the 1099 vs. W-2 call once, and document your decision

You need to make the 1099 vs. W-2 decision every time you hire someone. Look at the work, run through the checklist above, and document how you made the determination. If the role changes, such as a contractor who starts working for you full time, run through the checklist again.

If you have employees, you can run payroll from the same FreshBooks account you use to invoice clients and track expenses. FreshBooks Payroll, powered by Gusto, calculates and files payroll taxes for each pay run for supported tax agencies and jurisdictions. Talk to a specialist about FreshBooks Payroll.

Frequently asked questions

Is a 1099 contractor an employee?

A 1099 contractor isn’t an employee. If you control what the worker does and how they do it, the IRS treats them as your employee no matter what you call them.

Can the same person be both a W-2 employee and a 1099 contractor?

Yes, the same person can be both as long as the work is separate and distinct. If you split the same work between payroll and 1099 payments, the IRS may treat it as a worker-classification issue.

Is it cheaper to hire a 1099 contractor than a W-2 employee?

A 1099 contractor is sometimes cheaper overall than a W-2 employee because you don’t have to pay employment taxes, buy workers’ compensation, or provide employee benefits. But it depends on the contractor’s rate and the benefits you’d offer an employee.

Who decides if a worker is a contractor or an employee?

You decide. But if the IRS, DOL, or your state disagrees, they can overrule you.

What happens if a contractor should have been an employee?

If a contractor should have been an employee, you may owe back employment taxes, penalties, and interest to the federal and state governments. If you qualify, the Voluntary Classification Settlement Program lets you reclassify the worker going forward and get partial relief from penalties.

Do I send a 1099 to every contractor I pay?

No. You only need to send a 1099-NEC to contractors you paid $2,000 or more for services. You don’t include payments made to corporations or payments made by credit card or payment app.