Payroll
1099 vs W-2: How Small Businesses Should Pay Workers
Employees get W-2s and contractors get 1099s, but the difference goes beyond paperwork. Here's how to tell them apart and what each one means for taxes.
By Northlane Financials · October 19, 2026 · 2 min read
Short answer: A W-2 employee works under your direction, and you withhold and pay payroll taxes on their wages. A 1099 contractor runs their own business, controls how the work is done and handles their own taxes. Classification depends on the real working relationship, not on what you call the person. Getting it wrong can mean back taxes and penalties.
W-2 employees
When someone is an employee, you as the employer:
- Withhold federal income tax, Social Security and Medicare from their pay
- Pay the employer share of Social Security and Medicare
- Pay federal unemployment tax (Form 940)
- Pay Texas unemployment tax and file quarterly reports with the Texas Workforce Commission
- File Form 941 every quarter
- Give each employee a W-2 by January 31
1099 contractors
When someone is truly an independent contractor, you:
- Collect a Form W-9 before you pay them
- Pay their invoices without withholding taxes
- File Form 1099-NEC for contractors you paid at or above the IRS reporting threshold, generally by January 31
The contractor pays their own self-employment tax.
How to tell the difference
The IRS looks at the whole relationship, generally in three areas:
- Behavioral control. Do you control how, when and where the work is done?
- Financial control. Does the worker invest in their own tools, set their own prices, work for other clients and risk profit or loss?
- Relationship. Is there a written contract? Do you provide benefits? Is the work ongoing and a key part of your business?
The more control you have, the more likely the person is an employee.
Why misclassification is costly
If a worker you treated as a contractor is later found to be an employee, you may owe the payroll taxes that should have been withheld and paid, plus penalties and interest. Texas can also assess unemployment taxes.
Practical tips
- Get a signed W-9 from every contractor before the first payment.
- Keep contractor agreements and invoices on file.
- Review classifications whenever a role changes.
- When in doubt, ask before you pay.
How Northlane Financials helps
We run W-2 payroll, pay contractors, file 941s, 940s and Texas TWC reports, and prepare W-2s and 1099s every January. Learn more about our payroll services.
