Independent contractor vs. employee: Key differences, benefits, and compliance considerations

As the gig economy continues to expand¹, so has the shift in traditional working models. Today's workforce is more empowered than ever, with many prioritizing flexibility and freedom. So, for businesses, the question becomes: What is the best model for recruiting top talent? 

The most common models are the employee (W-2) model and the independent contractor (1099) model. Increasingly, companies are also adopting hybrid models that combine employees and independent contractors because today’s workers want options. 

In this article, we'll explore the differences, benefits, and considerations when deciding whether your business should use employees, independent contractors, or a hybrid approach. We will also explore what a worker should consider when looking to be an employee or independent contractor. 

1.  What is the difference between an employee and an independent contractor?
2. Benefits of being a 1099 independent contractor vs. a W-2 employee?
3. Pros and cons of hiring a 1099 independent contractor vs. an employee
4. Contractor vs. employee checklist
5. Contractor vs. employee test
   

What Is the difference between an employee and an independent contractor? 

The primary distinction between an employee and an independent contractor is the nature of their work arrangements. Employees work under the direct control of an employer, and they work exclusively for that employer. Employees are paid for their time, whether by the hour or a salary. Employers control how and when employees do their work, and the employees cannot substitute someone in their place. On the other hand, independent contractors control their work schedules and how they complete work. Independent contractors usually work with more than one customer, and they are paid for their performance at higher rates, usually on a project basis or some kind of piece rate basis, such as by the load delivered, house sold, or hair styling completed. 

Employees are covered by the employee benefits like health care insurance, workers compensation insurance, and retirement plans that employers vet and select. Employers deduct taxes from the employee’s paycheck. Independent contractors don’t get access to the company’s employee benefits, but they can shop for their own insurance and benefit plans. Independent contractors pay and file their own taxes after deducting their own business expenses from their revenue. 

Benefits of being a 1099 independent contractor vs. a W-2 employee 

From a worker's perspective, there are advantages to both working as a 1099 independent contractor and as a W-2 employee. Let's break it down. 

First, what is a 1099 and what is a W-2? 

When you hear someone talk about 1099s or W-2s, they are talking about tax reporting forms. These are forms sent to the IRS at the end of year reporting how much money a company paid a worker. If the worker is an employee, the money is reported on a W-2 Form, and the company reports how much money was already paid in taxes to the government, and how much money went to certain benefit expenses.  

If the worker is an independent contractor, the money is reported on a 1099 Form, and the company reports how much money they paid the independent contractor. The independent contractor then reports their own business expenses, taxes paid, and benefits. 

The IRS and state tax authorities then calculate how much the worker owes in taxes, or how much of a refund they get based on what the company and the worker report. 

Pros and cons of being an employee

It is important for workers to understand the pros and cons of being employees. Some of the biggest benefits are steady pay, predictable schedules, predictable work, and company-provided benefits such as insurance and paid time off. Some of the biggest drawbacks are lower rates of pay, a lack of flexible schedules, lack of work variety, and a lack of control over the work itself and workplace culture.  

Pros of being a W-2 employee:

• Steady Pay & Predictability: As an employee, you can expect regular paychecks and a consistent schedule, which provides financial stability. 

• Company Benefits: Many companies offer health insurance, dental and vision coverage, life insurance, and retirement plans such as a 401(k) that they select for their employees. Many companies also offer paid time off (PTO). 

• Professional Development: Employers often provide access to training programs, events, and other opportunities for skill development. 

• Simplified Tax Payments: Your employer handles payroll taxes, so you don't have to worry about setting aside money for income tax or Social Security contributions. 

Cons of being a W-2 employee:

• Less Flexibility: Employees generally have less control over their schedule and may find it difficult to adjust work hours or choose the projects they work on. 

• Income Growth Limitations: There can be limited opportunities for salary increases, especially if you're in a role with a defined pay range. 

• Lower Rates of Pay: Because employers are paying for company benefits, and contributing to taxes, employers pay employees less money.  

• Workplace Culture: You’re often subject to the company’s culture, and a poor work environment can lead to dissatisfaction. In fact, LinkedIn highlights that toxic company culture is the top reason employees leave their jobs.² 

Pros and cons of being a 1099 independent contractor

When deciding whether to become an independent contractor, it is essential to consider all the pros and cons. Some of the most significant benefits are flexibility and control, while the biggest drawbacks are inconsistent income and lack of company-paid benefits.  

Pros of being a 1099 independent contractor

• Flexibility & Control: Independent contractors enjoy greater freedom in choosing when and where they work, how they complete their work, and who they work for. You can decline projects and customers that don’t suit you. 

• Business Expense Deductions: Contractors can deduct business expenses such as equipment, travel, maintenance, insurance, and other work-related costs. 

• Diverse Work Opportunities: You can work with multiple clients, giving you a broader income stream, and deeper expertise. 

Cons of being a 1099 independent contractor

• Income Inconsistency: Your income may fluctuate due to varying project availability or the seasonal nature of some industries. 

• No Company Benefits: You’re responsible for your own health insurance, retirement savings, and other benefits that employees receive through their employers. 

• Tax Collection Responsibility: Unlike employees, independent contractors must manage their own taxes, which includes setting aside money for Social Security, Medicare, and income taxes. 

Hiring contractors vs. employees: pros and cons for businesses

For businesses, deciding whether to hire a W-2 employee or a 1099 independent contractor depends on factors such as cost, project scope, and the level of control needed. 

Pros and cons of hiring an employee 

Hiring a W-2 employee may be the more expensive route. You are paying their salary along with taxes and health insurance and may contribute to a retirement savings plan on their behalf. However, there are some great benefits of hiring an employee, most notably having more control over when and how work is completed. Hiring employees can also cultivate more loyalty from employees, and more tailored solutions for your customers. 

Pros of hiring a W-2 employee: 

• Stability & Loyalty: Offering employee positions with benefits can create a more loyal workforce developing critical, unique solutions for you and your customers. Employees feel more secure and invested in their roles, which can lead to higher productivity and better work quality. 

• Easier Integration:Employees are often more integrated into the company's culture and operations, leading to better team collaboration and communication. 

• Control over work: Typically, with employees you are able to control the projects worked on, how they are completed, and when they are completed.  

Cons of hiring a W-2 employee: 

• More Fixed Costs: Hiring and firing employees is a slow process, and employees come with fixed costs like salaries and benefit costs. When work spikes and descends, it is hard to adjust your costs with employees. So employers are forced often to carry more employees and fixed expenses to meet the spikes in customer demand.  

• Less Expertise: Employees become experts in you, but they don’t gain the expertise that comes with working with multiple companies in the same industry, or with focusing on work that is not in your company’s wheelhouse. 

Pros and Cons for Hiring a 1099 Independent Contractor 

Consider hiring a 1099 independent contractor if your business needs don't require typical full-time working hours or if you have a project requiring specialized skills. One of the most significant benefits of utilizing an independent contractor is that they have specialized skills and are more cost-effective than a full-time employee because they are a variable cost, not fixed. One of the most significant drawbacks of utilizing an independent contractor is that they may have limited availability since they often work with other companies, and you lose control over the details of their work.  

Pros of hiring a 1099 independent contractor: 

• Variable Costs: Independent contractors are paid a higher rate of pay, but that is a variable expense that is easier to manage. They don't require the same fixed expenses like salaries and benefits that you must pay whether you have the work or not. With independent contractors you pay only for completed work. 

• Specialized Skills: Contractors are often experts in their field, allowing you to bring specialized skills for specific projects without long-term commitments. 

Cons of hiring a 1099 independent contractor: 

• Availability: Since contractors typically work with multiple clients and have the freedom to choose their projects, they may not always be available for work you need done. 

• Lack of Control: Because they are independent, you cannot dictate precisely how or when contractors complete their tasks. 

Contractor vs. Employee Checklist 

Many different courts and agencies determine whether a worker is an employee or an independent contractor. Those include workers compensation judges, state unemployment offices, state and federal labor departments, as well as courts of law. The IRS is just one of many agencies that have a say in whether a worker is an employee or an independent contractor, but their guidelines are used by many courts and agencies. The contractor vs. employee checklist refers to the three main categories the IRS uses to assess interactions that define a worker as an employee or contractor. Those three categories are behavior, financial, and type of relationship.³ 

Behavior refers to how much control an organization has over HOW a worker does a job. As a 1099 contractor, you can use your methods to complete work, and a company may provide feedback on that work when complete. Organizations have more control over their employees if they are dictating where, when, and how the job is completed. Employees are typically given more detailed evaluations and instructions for completing their work.   

Financial refers to the financial differences between an employee and a contractor. One of the main differences is that a 1099 independent contractor will invest in their materials and equipment, while an employee is usually supplied with that equipment by their employer. Payments to each are also a point of differentiation. Employees receive regular and consistent wages over a period of time, while 1099 independent contractors typically earn a flat fee or percentage of revenue for a job.  

The type of relationship is a crucial component of defining employee vs. contractor. As mentioned earlier, employees receive company benefits such as insurance and paid vacation. Benefits aren't afforded to an independent contractor by the employer. An employee is usually hired to work indefinitely while a contractor is hired for a project or to perform a specialized service.  

Independent Contractor vs. Employee Test 

While the IRS 20-factor test is no longer the IRS official test, they will still consider some of these factors, so it acts as a guide to helping you properly classify your workforce.   

Misclassifications can be highly time-consuming and costly, so you want to ensure the correct processes are in place.  

Here are the factors:⁴ 

1. Instructions: Does the company control how, when, and where the work is done? If the worker must follow detailed instructions, they may be classified as an employee
   
   
2. Training: If the company provides training to the worker, this indicates employee status. 
3. Integration: When the worker's services are integrated into the business, this suggests employee status because their role is crucial to the company
4. Services Rendered Personally: If workers must perform the services personally, they are more likely to be considered employees. 
5. Hiring, Supervising, and Paying Assistants: Employees typically work under the employer's supervision, while contractors hire and pay their own assistants. 
6. Continuing Relationship: A continuing relationship between the worker and company suggests employee status. 
7. Set Hours of Work: Employees are typically required to adhere to set hours, while contractors usually set their schedules. 
8. Full-Time Requirement: Employees are often required to work full-time for a company, while contractors can work for multiple clients. 
9. Work Done on Employer's Premises: Employees often work on the company's premises, whereas contractors can work offsite. 
10. Order or Sequence Set: If the company controls the work order, this indicates employee status. 
11. Oral or Written Reports: Regular reports on work progress indicate employee status. 
12. Payment Method: Employees are paid regularly (hourly, weekly, etc.), while contractors are typically paid per project. 
13. Expenses: Employees are generally reimbursed for business expenses, while contractors cover their costs. 
14. Tools and Materials: Employees are usually provided with tools and materials, while contractors provide their own. 
15. Investment: Contractors often invest in their own work facilities, while employees rely on the company. 
16. Profit or Loss: Contractors have the potential for profit or loss, whereas employees are paid a consistent wage. 
17. Works for More Than One Person or Firm: Contractors typically provide services to multiple clients, while employees work for one employer. 
18. Offers Services to General Public: Contractors advertise their services to the general public, unlike employees who work for one company. 
19. Right to Discharge: The company can fire employees, while contractors cannot be terminated without risking a breach of contract. 
20. Right to Quit: Employees can quit their jobs at any time, while contractors must fulfill the terms of their contract. 
    

Conclusion

Workers' decisions about whether to become a 1099 contractor or a W-2 employee depend on their priorities. Flexibility and control often appeal to independent contractors, but employees benefit from stability, consistent income, and comprehensive benefits. 

For businesses, deciding whether to hire an employee or contractor depends on the specific needs of the project or role. Independent contractors are excellent for short-term, specialized work, while employees offer long-term commitment and deeper integration into the organization. Just be sure to classify workers properly to avoid misclassification risks. 

Sources: 

1. Broda K. Gig economy – the economic backbone of the future? [2021]. brodmin - a late payment reporting directory. February 2022. https://brodmin.com/case-studies/gig-economy-case-study. 

1. Schultz C. The leading reasons your employees may leave. https://www.linkedin.com/pulse/leading-reasons-your-employees-may-leave-carol-schultz. Published July 20, 2023. 

1. Mmyers. Checklist for IRS 1099 vs W2 Employees. Welcome to 1099-etc. Your All Inclusive Payroll Suite! https://1099-etc.com/blog/1099-w2-forms/irs-1099-vs-w2-2/. Published March 3, 2022. 

1. IRS 20 Factor Test – Independent Contractor or Employee? https://www.oregon.gov/oda/shared/Documents/Publications/NaturalResources/20FactorTestforIndependentContractors.pdf.