Most people make their living collecting a paycheck.
Whether you work full time or part, hourly or get paid by the year, the majority of work out there is what is called a “W-2” position. It means that someone else has hired you to do a job. You do it, get paid for it, and are taxed as an employee. (And if any of those things aren’t true then you should probably talk to a lawyer...)
At the end of each year, your employer generates a W-2 form stating your total earnings and the taxes you paid on them.
However a growing number of Americans earn their living another way. These are the freelancers and the self-employed. They never see a W-2 form. Instead, they get a 1099.
What Is a 1099?
A 1099 is a tax form generated for anyone who has earned money as a contract worker.
Like a W-2, businesses send out a 1099 form at the end of each year to anyone who they’ve paid during the previous year. It states the person’s total earnings from that past year, along with who paid those earnings and any other information relevant to the tax status of the paying entity.
However, a W-2 will also contain information about income and payroll taxes withheld over the year. A 1099 does not, because businesses that pay contract workers don’t withhold or pay any taxes on their behalf.
Both documents have the same role, though. They are the end-of-year earnings statement that workers use to file their income taxes. They tell you how much taxable income you earned and, as a result, how much money you need to report on your 1040. While a W-2 is generated by employers for employees, a 1099 is generated by anyone who paid a contract worker more than $600. Most people who get a W-2 will receive only one, while most people who get a 1099 will receive several because they’ve done work for multiple clients.
What Is a Contract Worker?
A contract worker, often known as a freelancer, is anyone who has been hired to produce or deliver a specific product or service. This arrangement is sometimes known as “work for hire,” because the person literally has been hired to do a specific piece of work.
For example, a company might hire someone to paint a mural in their lobby. This artist will have been contracted to deliver one specific piece of art after which their relationship with the company may or may not end. The company doesn’t need someone to produce artwork on an ongoing basis; they just need that one painting.
Contract workers have become very common in the modern economy. Almost anyone on the product-delivery end of most sharing economy apps is a freelancer. The Uber (UBER) - Get Report driver, the Grubhub (GRUB) - Get Report cyclist and the Airbnb host all have a work-for-hire contract with their employer. Each delivers a specific product (a ride, a delivery and a night’s stay) in exchange for payment.
Many journalists (such as this writer) are contract workers. In fact, the freelance journalist is one of the most established versions of freelance employment. And a growing number of companies have begun relying on contract workers to do jobs they once would have hired a staff member for.
Contract Workers vs. Employees
In practice, specificity is the main difference between a contract worker and an employee. Someone who has been brought in to perform a general job function or who has been hired to show up for a period of time and work as needed is an employee, or should be one. By contrast, someone who has been hired to do one, specifically identifiable and identified job is a contractor. (The formal definition is a multi-part test based on behavior, finances, workplace and restrictions.)
Take, for example, a retailer. Most retailers need staff to be generally available in case customers come in and need help. This is an employment relationship because the worker is available for a period of time (their shift) at a particular place (the store) to do general work. By contrast, say a retailer needed to close a specific sale. They might hire a contractor to come in and sell one particular piece or to sell to one customer in particular. This is a specific contract (sell this item, work with this person) and as such can be contracted.
The other main difference between an employee and a contract worker is what lawyers call “time, place and manner restrictions.” If a business wants to control the hours during which someone works, the place in which they do that work or the manner in which they produce their work, they have to hire the person.
For many freelance workers this is the main appeal of their job. They can work where, when and how they please. Indeed, it is very common for freelancers to have longstanding relationships that verge on employment with a specific business, but to keep their contractor status because they like the independence. This writer, for example, has been a reporter with TheStreet since 2013, but has remained a contracted contributor rather than an employee for that exact reason.
I like writing at midnight, waking up at 9 and never having to show up in an office.
Taxes and the 1099
The 1099 is different from the W-2 because contractors pay their taxes differently from employees. This shows up in two main ways:
Although the income tax is technically a self-reported tax paid by everyone who earns income, in practice few people actively pay any taxes. Instead, employers estimate an employee’s likely tax burden based on their income then automatically withhold that amount from their paycheck and send it to the IRS. Since this doesn’t account for deductions and credits, most people have more withheld from their paycheck than they actually owe in taxes. The result is that most people receive a refund on their taxes each year.
None of this applies to contract workers.
Someone who pays a contract worker does not withhold taxes, since it is considered a payment for services rather than necessarily income. As a result the 1099 has no tax payment information. Instead the contractor has to pay their own taxes in full. This means not only paying taxes every April, but also making estimated payments to the IRS every three months. (This system of quarterly payments is supposed to ensure that taxpayers don’t let their tax burden build up to unsustainable levels. In practice many contract workers don’t fully anticipate their actual income taxes.)
- The Self Employment Tax
Payroll taxes are separate from the income tax. They are taxes that apply to all income and are used to fund Medicare, Medicaid and Social Security.
Every dollar of earned income over $400 and under $132,900 is subject to the payroll tax, which comes to 15.3%. Of this, in an employer/employee relationship, each party pays half. As a result, a W-2 worker has 7.15% of each paycheck withheld for payroll taxes.
Contract workers, being self-employed, don’t have anyone to pay that other half of payroll taxes. As a result, they pay both halves. It comes to an intentional, designed-in 7.15% tax increase on everyone who works for themselves.