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.
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
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:
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.
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.
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Here’s what the forms have in common:
And here’s how the forms differ:
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.
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.
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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.
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.
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Misclassification isn’t just a tax issue; it’s one of the most common causes of lawsuits.
If you have any doubts about how to classify workers, it's crucial to get legal counsel or delegate
the task to a mediator.
Mellow helps you work with independent contractors legally and safely.
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