1099 vs. W-2: Key Differences Every Employer Must Know to Avoid Risk

The IRS has different rules for reporting hires of U.S. employees and contractors, and different forms for each: the W-2 for employees, and the 1099 for contractors.

‍

In this article, we’ll discuss the differences between the two forms, how to avoid penalties when filing them, and which employer obligations and worker rights are associated with each.

‍

‍

What is the W-2, and when is it used?

‍

Form W-2 is a tax document filed with the IRS that reports the income of regular employees (also called W-2 workers). As of January 2025, there were 162 million such employees in the United States.

‍

‍

Employer responsibilities toward W-2 workers

‍

• Withholding taxes (federal, state, Social Security, and Medicare)
• Paying benefits (Paid vacations, health insurance, 401(k))
• Determining the employee's schedule and responsibilities

‍

Example

‍

Lisa works for a marketing company. Her pre-tax salary is $5,000 per month. Here are the taxes her employer will withhold and pay:

‍

‍

‍

What is Form 1099, and when is it needed?

‍

Form 1099 is a tax document that employers use to report non-traditional employment benefits. There are 22 versions of the form, but the two most important ones for businesses are 1099-MISC and 1099-NEC.

‍

• 1099-MISC covers miscellaneous income, including rent, legal fees, prizes, and awards. Prior to 2020, the 1099-MISC also covered payments to freelancers and independent contractors, but now the 1099-NEC is used for that purpose. (The creation of a separate form was due to the rapid growth of freelancing: it’s predicted that by 2027, freelancers will account for 50.9% of the total labor force in the United States.)

• 1099-NEC is used to report payments to contractors, freelancers, and self-employed people who pay their own taxes and don’t receive benefits. It needs to be filed if the 1099 worker earned $600 or more for the year.

‍

‍‍

Example

‍

In 2024, an American software company hired two freelancers. Anna from Poland worked from January through December and was paid $75,000. Juma from Kenya was hired for a short project and received $400.

‍

Anna’s annual income exceeded $600, while Juma’s did not. Therefore, the company had to complete Form 1099-NEC for Anna and file it with the IRS by January 31, 2025. (Contractors’ country of residence does not affect reporting.)

‍

‍

Sometimes a 1099-NEC isn’t required — see page 3 of the IRS’s instructions.

‍

{{_highlight-module-orange}}

‍

‍

1099-NEC vs. W-2: Comparison

‍

Here’s what the forms have in common:

‍

• The filing deadline is January 31.
• Mandatory electronic filing if an employer files more than 10 returns from this list (which includes both the 1099 and W-2). 
• Retention requirement for copies: 4 years.

‍

And here’s how the forms differ:

‍

‍

‍

Risks of misclassification

‍

If misclassification is proven, businesses face fines and reputational losses. The misclassification of workers as contractors deprives workers of their rights and results in lost tax income of billions of dollars for the government. In the U.S. construction industry alone, up to 2.1 million workers are misclassified or paid unreported wages.

‍

‍

Risks for employers

‍

Fines and criminal penalties

‍

If the IRS finds an intentional misclassification, the employer will face penalties of up to 20% of all wages paid, plus 100% of FICA taxes. There can also be fines of up to $1,000 per misclassified employee or even a year in jail for the person responsible for withholding taxes.

‍

Reputational risks

‍

An employer’s brand affects how easily it attracts talent, as well as its turnover. Employers understand this: according to Speakers Corner, 88% of executives consider reputation management more important than employee training.

‍

Misclassification can affect a business’s reputation, which can lead to decreased employee morale, layoffs, lost profits, weaker corporate culture, and lower investment attractiveness.

‍

‍

Real cases of worker misclassification

‍

• In 2023, Uber and Lyft settled a wage theft lawsuit for $328 million.
• In 2024, Arise misclassified at least 250 workers and was ordered to pay $2 million.
• In January 2025, The Party Staff, a hospitality staffing company, filed a lawsuit alleging that three competitors were illegally misclassifying workers as contractors.

‍

{{_highlight-module-grey}}

‍

‍

How to determine if a worker is an employee or contractor

‍

In U.S. federal law, worker classification is based on the Economic Reality Test established by the FLSA, which looks at six factors.

To determine a worker's status, ask questions about each criterion and check the answers against the table.

‍

‍

It’s important to remember that job titles, payment methods, work schedules, and so on do not determine worker status. What matters, at least under federal law, are the factors above — though individual states also have their own regulations.

‍

If, after applying this test, you still aren’t sure whether the worker is an employee or a contractor, you can file Form SS-8 with the IRS to get an official ruling.

‍

‍

W-2 vs. 1099: what to consider

‍

The right choice between a W-2 and 1099 depends on the type of relationship between the company and the person, and misclassification can result in fines and reputational damage.

‍

To avoid risks, consult with professionals. Mellow helps companies work with independent contractors around the world, reducing risks and simplifying processes. Book a free demo and learn how to optimize your hiring today.