This information was updated on January 22, 2021.

As a business owner, it's important to be familiar with certain tax forms, specifically the W-2 and 1099. With a proper understanding of the differences between these forms, you can help reduce the chances of tax errors and potential fines.

The main difference between the forms

Although the W-2 and 1099 forms are both information statements, the purposes they serve and the types of worker they represent are different.

  • Form W-2 is a wage and tax statement you issue to employees. When an individual performs services that are controlled by you, and you are the one that determines what will be done or how it will be done, the individual should be classified as an employee, according to the IRS.
  • Form 1099-NEC is for income paid to non-employees, such as independent contractors. The IRS says the worker 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." Earnings from independent contractors are also subject to self-employment tax.

What must be reported

The following must be reported to the IRS depending on which worker classification you choose:

  • Use Form W-2 to report wages, tips and other compensation paid to an employee. You must report the employee's income and social security taxes paid. You also need to report wage and withholding information to the employee and the Social Security Administration (SSA). Subsequently, the SSA shares the information with the IRS.
  • Use Form 1099-NEC for non-employees to "report payments of $10 or more in gross royalties or $600 or more in rents or compensation," to both the IRS and the individual who received the payment.

Be careful when filing

You can face repercussions for using the wrong form to classify workers. If you misclassify a worker as an independent contractor, you risk increased tax bills and penalties for not paying the appropriate employee taxes and for using the wrong form. You may also be subject to penalties for failing to take appropriate state withholding and deductions, plus levies for not making contributions to state disability and unemployment agencies.

The IRS penalty per statement for failure to file, or to failure to furnish accurate Forms W-2 and 1099 (including accurate names and Social security Numbers) is $280 per statement, with an annual cap of over $3.3 million.

Also, due to the Fair Labor Standards Act (FLSA), employers may potentially be liable for unpaid overtime for any misclassified workers. According to the IRS, if the worker is an employee, "you must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to an employee. You do not have to withhold or pay any taxes on payments to independent contractors."

Therefore, you must have an understanding of the business relationship between you and your workers. The IRS provides important information regarding this relationship and further offers common law rules to help small businesses make the correct classification.

If you're experiencing trouble, you can use Form SS-8 called "Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding" and file it with the IRS, who will then officially make this determination for you. Besides Form SS-8, there are a variety of other tests that are used to determine whether a worker is properly classified.

Some state laws distinguish employees and contractors differently than federal law. In 2019, California enacted AB 5, which generally classifies workers as employees unless certain specific criteria are met. Many other states have different rules.

Businesses should also be aware that it may be necessary to file forms 1099-NEC with the state tax authorities. Previously, if a business filed Forms 1099-MISC to the Internal Revenue Service, the IRS would forward the form to the state as part of the Federal/State Filing Program. The IRS announced in 2020 that this program would not be in place for Form 1099-NEC. Many states have announced that businesses must file these forms to the state directly.

Consult a legal or tax adviser if you have additional questions about these classifications or are unsure how to treat a particular worker. Understanding the difference between Form W-2 and Form 1099-NEC may help you avoid tax errors and fines.

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