W2 vs. 1099-NEC: Which does my business have to issue?

Deciding whether to use Form W2 or Form 1099-NEC depends on which type of worker you're reporting payments for. Classifying workers is one of the more controversial topics businesses need to address. While it may seem easy, there's no universal agreement about when a person should be classified as an employee versus when they should be classified as an independent contractor.

About W2 and 1099-NEC forms

W2 and 1099-NEC are tax information forms that the Internal Revenue Service (IRS) requires businesses to prepare and file annually to report payments made to different types of workers. The due date for both forms is Jan. 31. That's when you'll need to have them mailed or electronically sent to the people you paid. You'll submit the W2 forms to the Social Security Administration (SSA) and 1099-NEC to the IRS. Once the SSA processes the forms, they'll send your information to the IRS.

When to use W2 forms

W2 forms are used to annually report the wages paid to workers who are employees of the business. Employees are often given set work hours, provided with the tools they need to do the work, given instructions and training, and are hired for an indefinite period of time. When taken together, those traits distinguish that the person is an employee.

When to use 1099-NEC forms

Form 1099-NEC is used to annually report payments made to nonemployee workers who provided services to a business. NEC stands for nonemployee compensation. You'll need to complete the 1099-NEC form and report that to the IRS. The information used to be reported on Form 1099-MISC until tax year 2020.

People who receive nonemployee compensation are often referred to as independent contractors or freelancers. What separates them from employees is that the working relationship differs and is often governed by a written or verbal contract for a specific project or duration. They are free to work for other companies and on a schedule that suits them as long as they comply with the terms of the contract.

Differences between independent contractors and employees

When businesses hire employees and create an employment relationship, they're obligated to withhold Social Security and Medicare taxes. This is a 15.3% tax assessed on the employee’s total wages—half of which is paid by the employer and the other half by the employee. Generally, businesses must also withhold federal and state income taxes as well as pay unemployment insurance in most states when there is an employment relationship. They also must follow state and federal requirements regarding minimum wages, overtime laws, child labor laws, and recording requirements. It can be a lot of work.

With independent contractors, the burden is on the worker to pay self-employment taxes (Social Security and Medicare), not the business. Since they're not employees, businesses typically don't pay for health insurance or other benefits for their contractors.

When businesses use independent contractors, they save money on administrative expenses and taxes and are outside the parameters of the Federal Labor Standards Act. Therefore there is less regulatory burden on them.

The consequences of using the wrong form

The government does not take tax evasion lightly, so if you're caught intentionally misclassifying employees as independent contractors, you could be subject to paying back tax payments, large fines, interest, legal fees, back wages, and benefits, and may even face jail time. And if you didn't misclassify them intentionally, or you feel that they are classified correctly, you can appeal their decision and present your case. If you need to reclassify workers, the IRS has a voluntary program that could help you with the process.

Business obligations for 1099-NEC and W2 filing

Review your payroll and accounts payable records throughout the year and examine your worker classifications to be confident that you report each individual correctly. Send your W-2 and 1099-NEC forms out on or before Jan. 31 annually (or the following business day when it falls on a weekend) to the workers you paid and to the government, and you'll be well on your way to full compliance.