Team Digits

Published February 06, 2025

1099 vs. W-2: The Pros and Cons for Your Startup

Bootstrapping a startup means trying to stretch your funding as far as possible. Salaries are often a founder’s biggest expense — but if you pay under market value, you won’t get the talent you need to succeed. Forgoing W-2 employees and using 1099 contractors may seem like a good way to hire top-of-the-line people without running yourself out of business.

However, working with freelancers brings its own set of challenges: You must follow IRS and state regulations regarding what you can require of contract workers. The penalty for breaking these laws is steep.

Many founders opt to wing it when hiring, choosing the solution that seems most cost-effective at the moment. Like every other part of the hiring process, your employee classification decisions should be made thoughtfully and with an eye on the future. Here’s how to choose between hiring 1099 vs. W2 workers.

1099 vs. W-2: What’s the difference?

The key difference between 1099 and W-2 workers is the amount of control you have over their work. 1099 workers are also known as independent contractors for a reason: While they have a work arrangement with you, they are only obligated to deliver the product or service you contracted them for. Contractors choose how to complete their work and control their own schedules.

When you’re working with a contractor, you can’t order them to work in the office every day from 9 - 5. You can’t tell them they have to work in a certain program (though you could specify a certain file type you need the final product to be). And you can’t require a contractor to refuse other work, even if it’s similar to the service they’re providing to your company.

W-2 employees, on the other hand, have a tighter work relationship with your company. You can direct both what they do and how they do it. They’ll typically work with company tools (laptops, software, etc.) and on a schedule determined by their manager. W-2 employees are with your company for the long haul rather than coming and going as projects dictate.

What you need to know about hiring W-2 employees

Many of the people who work at your startup will be full employees. W-2 employees are fully trained by your company and embedded into it in a way contractors are not. For one, their skills and expertise remain on tap as your company grows. While they’re hired into an official role, you can shift their duties as needed.

Startups may hire employees to fulfill roles like:

• Handling ongoing scheduling and other administrative tasks that require knowledge of the company’s workings and systems
• Planning your product development timeline, coordinating freelancers and employees, and bridging the gap between executives and individual contributors
• Managing your operations, including duties like hiring and training, that require strong relationships with managers and executives

When you hire a W-2 employee, you’re investing in a person, not a product or outcome. Your employee will (hopefully!) grow in their role and perhaps even win a promotion when they gain the skills to help your company at a higher level. Unless you hired them for a temporary position, they’re with your company until you or they decide the employment arrangement should end.

Pros and cons of hiring employees

On paper, hiring employees costs more — but sometimes, that extra investment is worth it.

Benefits of employee workers include:

• Greater control: You have more say over how they perform their job. If you want them in the office for set hours or need them to use a Windows PC instead of a Mac (or vice-versa), that’s your right as an employer.
• Improved team cohesion: Because employees signed up to be with your company and only your company, they’ll spend every day working with the same team. Over time, they’ll learn each other’s strengths and weaknesses and work together more smoothly.
• Higher loyalty: Employees’ jobs rely on your company’s continued success. This incentivizes them to work hard and do their best.
• More stability: Employees work for the good of your company, not for the success of a specific project. They can be pulled onto assignments to help during a big crunch or cover someone else’s duties. They also accrue institutional knowledge that’s important to your success but may not be officially documented.

Cons of employee workers include:

• Higher costs: When you hire an employee, you’re required to pay for benefits like health insurance, paid time off, and other perks. You’ll also pay half of their Social Security and Medicare taxes.
• More administrative work: Hiring employees requires heavier documentation on your part, plus compliance with employment laws.
• Less flexibility: Scaling up (or down) takes more time when working with employees vs. contractors. You’ll need to go through a full hiring process, potentially wait for your new hire to transition out of their old job, and then do a full onboarding. Once you reach a certain size, you’ll also have to follow rules for layoffs.

While there’s no one answer to “Is it better to hire employees or independent contractors?” there’s a reason most Fortune 500 companies don’t solely run on freelance workforces.

Tax implications of W-2 employees

Some of the administrative work mentioned above will go toward paying employee taxes. As an employer, you are responsible for:

• Federal and state income tax withholding: The employee decides how much they want withheld from their paycheck, but your company will be responsible for remitting those taxes to the relevant agencies.
• Payroll taxes: Employers pay half their employees’ Social Security taxes and Medicare taxes, which comes out to 7.65% of their salary. These are known as the Federal Insurance Contribution Act, or FICA, taxes.
• Unemployment taxes: Employers must pay federal (FUTA) and state (SUTA) unemployment insurance taxes.
• Workers’ compensation insurance: Most states require you to provide workers’ comp for all employees to cover injuries that happen in the workplace.
• Regular reporting: Your company will file quarterly and annual payroll tax returns and is responsible for providing tax form W-2 to employees.

As you can see, there are a lot of details here to keep track of. Most business owners work with accountants (like ours!) to ensure they stay compliant.

How to file form W-2

Filing a W-2 requires you to have your business information and your employee’s information on hand. Boxes A, E, and F will have your employee’s information; boxes B, C, and D are for your company information.

Then, you’ll need to fill out employees’ wages and tips (Boxes 1 and 8, if applicable), tax withholdings (Boxes 2, 4, and 6), and the amount of their wage subject to Social Security and Medicare taxes (Boxes 3, 5, and 7, if applicable). Much of this information will be repeated in the state wages section (Boxes 15-20). Boxes 10-14 don’t apply to every employee; check with a tax expert if you’re not sure whether you need to fill them out.

Copy 1 should be filed with their state or other local tax authority. Copy 2 and Copy B go to the employee for filing with their state and federal tax returns, respectively. Copy C is theirs for their records, and Copy D is for your company’s records. W-2 tax forms must be sent by January 31st of the year following an employee’s work.

What you need to know about hiring 1099 contractors

Small business owners typically hire independent contractors when they need a specialized skill set or certain expertise to complete a specific project or initiative. You can bring a contractor on board to benefit from their knowledge without having to find the budget for another employee.

Some examples of contractors startups might hire include:

• A branding specialist to develop your company’s logo and wordmark
• A growth consultant to create a go-to-market plan for your marketing team to execute
• An app developer to turn your web app into a mobile app

1099 contractors may work with one or two points of contact at your company, or they may interact with full teams. However, they’re ultimately there only for the time it takes to complete the project or scope of work.

Pros and cons of hiring independent contractors

Independent contractors are less expensive for a company trying to keep things lean, but short-term workers typically bring short-term benefits.

Pros of independent contractors include:

• Cost savings: Independent contractors pay self-employment tax, so your company won’t have to cover payroll taxes or coordinate withholding. They also don’t qualify for employee benefits like insurance, PTO, or retirement plans.
• Greater flexibility: Because contractors work on an as-needed basis, it’s easier for you to wind up or wind down staffing as your budget allows. Working with freelancers also enables you to pivot quickly and choose people with the right expertise for your company’s current needs.
• More specialization: Contractors bring expertise you might not have access to in-house. You may not be able to pay a network security engineer salary, but a consultant could design and implement security measures for a lower project rate.
• Fewer compliance risks: Freelancers have fewer legal protections, so you’re less likely to run afoul of laws and regulations.

Cons of independent contractors include:

• No employer control: You don’t get to tell an independent contractor how to do their job. They can work at their own pace and choose their own hours. If you want someone who’s plugged into your team, a contractor would be a poor fit.
• Risk of misclassification: Just because you pay someone with a 1099 doesn’t mean they’re an independent contractor. If you break federal or state laws regarding who can and can’t be considered a freelancer, you could be on the hook for serious fines and penalties.
• Less investment: Contractors come in, do their job, and get paid — whether or not your company succeeds in the long term. A good independent contractor takes pride in their work, but they’re less likely to go above and beyond or pick up the slack if they see something else that needs to be done.

Because independent contractors have fewer ties to your company, relying too much on them could leave you with a lack of internal talent and big knowledge gaps that you’ll need to run your day-to-day. Plus, contractors doing company essential work are likely misclassified (more on that later).

Tax implications of 1099 workers

Handling payroll and taxes for 1099 workers is much easier than it is for W-2 employees. We don’t even have a bullet-point list for them. All you need to do is send form 1099-NEC to any contractor who has earned more than $600 from your company in the past year.

Your company doesn’t withhold taxes for 1099 contractors, nor are you responsible for FICA and other employment taxes. They’re not eligible for workers’ compensation (or other benefits).

How to file form 1099-NEC

Filing a 1099-NEC is easy: You’ll need to input the contractor’s full legal name, your Taxpayer Identification Number (TIN), the contractor’s Social Security Number (SSN) or TIN, their address, and the total amount you’ve paid them in the tax year.

Copy A goes to the IRS, Copy B goes to the contractor, and Copy C becomes a part of your company’s records. 1099 tax forms must be sent by January 31st of the year following the contractor’s work for you.

Misclassification of workers: A critical IRS concern

Hiring someone as a contractor while treating them as an employee is against employment law. Enforcement agencies take this transgression seriously. Self-employed workers trade the security and perks of a W-2 job for the freedom to be their own boss. If the law determines they’ve lost that freedom, your company will be on the hook for unfair employment practices.

Employee classification tests

Depending on where you live, there are one or two tests you’ll need to apply to determine if a role should be classified as a W-2 employee or a 1099 independent contractor.

The IRS common law rules use three categories to determine a worker’s rightful classification. Ask yourself these questions regarding the following categories of your employment agreement:

1. Behavioral Control: Do you have the right to control what the worker does and how they do it?
2. Financial Control: Do you control business aspects like how the worker is paid or whether expenses are reimbursed?
3. Type of Relationship: Are there contracts, benefits, or an expectation of an ongoing relationship? Is the work a key aspect of your business?

If you answered yes to any of these questions, you may need to classify the worker as an employee. All categories are considered together, so one “yes” doesn’t guarantee that person is an employee.

Many states have stricter rules than the federal government. A worker who counts as a contractor under federal law may still need to be a W-2 employee if they work in one of those states. The most common test used by states is the ABC test, where all three need to be true:

• The individual free is from your control and direction, both under contract and in fact, for the performance of the work.
• The individual performs work that is outside your company’s normal course of business.
• The individual established themself as a worker in the trade, occupation, or business for which you have contracted them.

Under the ABC test, the answer to all three of these questions must be “yes” for an employee to be considered an independent contractor. As of 2025, thirteen states use the ABC test, so be careful if you’re hiring in any of them.

Both the federal classification test and the ABC test questions are somewhat subjective. We recommend consulting a lawyer so you can be confident in your worker classification choices.

Penalties for misclassification

The Silicon Valley ethos of “move fast and break things” should not be applied to your employment practices. Mistakenly identifying a W-2 employee as a 1099 contractor can be extremely expensive. Companies that make this mistake may have to pay the federal government, the state government, and the misclassified individual.

The federal penalties for unintentionally misclassifying an employee are:

• A fine of $50 per form W-2 the employer failed to file
• Back taxes equal to 100% of the FICA taxes the employer should have paid
• A penalty equal to 1.5% of the wages plus 40% of FICA taxes that were not withheld from the employee
• A Failure to Pay Taxes penalty equal to 0.5% of the rapid tax liability for each month, up to 25% of the total liability

The penalties accrue interest from the date the tax payments should have been made.

If the IRS determines you willfully misclassified an employee, you could be subjected to penalties of up to 20% of all the wages paid plus 100% of FICA taxes — both your share and the employee’s share. The IRS may also pursue criminal penalties of up to $1,000 per misclassified worker and a year in prison.

States may further penalize you for misclassification. For example, in California, you would be prohibited from using employee labor until you were back in compliance, and you’d have to pay back taxes, unemployment insurance fees, and penalties.

Finally, a misclassified individual can bring a civil claim against your company for violating the Fair Labor Standards Act (FLSA) and other labor laws. They may be able to receive back wages (including unpaid overtime) and compensation for the benefits they did not receive, like insurance coverage, paid leave, and severance pay. Don’t forget that losing a lawsuit also means you’ll have to pay that person’s legal fees.

These penalties add up quickly, especially if you’ve misclassified multiple employees or kept a worker misclassified for a long time. Our advice: Make sure a knowledgeable HR employee oversees all staffing decisions so you don’t make this mistake.

Best practices to avoid misclassification

So, how do you make sure you’re hiring the right types of workers for each job? Start by evaluating each new position under any applicable tests before you make the hire. You may want to talk to a lawyer as part of this evaluation.

Then, keep detailed records of the reasons you classified a worker as a contractor instead of an employee. You’ll want these if questions ever arise surrounding the worker’s status, even if just to prove it was an unintentional misclassification. HR should maintain these records.

Finally, find an accountant or another tax professional to ensure you meet all your tax obligations for W-2 employees and 1099 contractors alike. Our tax experts can keep you on the up and up.

The accounting know-how your startup needs

We don’t want to brag too much, but our accounting solution comes with access to CPAs to help you file your taxes.

Most founders don’t have that level of expertise. With Digits, you get the win-win-win of GAAP-compliant automated books, expert human help, and no extra demands on your time.

Contact Digits today to see how we can help your startup upgrade its finances.