The core difference comes down to control. W-2 employees work under your direction. You set their hours, tell them how to do the job, and provide the tools they need. Contractors operate independently. They control how and when they complete the work, often serve multiple clients, and typically provide their own equipment.

Tax responsibilities change depending on the classification. With W-2 employees, you withhold income taxes, Social Security, and Medicare from their paychecks. You also pay the employer half of Social Security and Medicare taxes, plus federal and state unemployment taxes. With 1099 contractors, you don’t withhold anything. They handle their own income taxes and self-employment taxes.

The paperwork differs too. Employees receive a W-2 form by January 31 showing their wages and withholdings for the year. Contractors receive a 1099-NEC if you paid them $600 or more. Payroll processing for employees involves more administrative work upfront and ongoing compliance, while paying contractors is simpler on your end.

From a cost perspective, employees are more expensive than their hourly wage suggests. Beyond the paycheck, you’re paying employer payroll taxes around 7.65% for Social Security and Medicare, plus unemployment insurance. Contractors cost what you agree to pay them, nothing more. But that doesn’t mean you should classify everyone as a contractor to save money.

Misclassification is a serious issue. The IRS and Michigan state agencies look closely at how workers are actually treated, not just what you call them on paper. If you control when someone works, provide all their equipment, and they only work for you, calling them a contractor doesn’t make them one. Getting caught misclassifying employees means back taxes, penalties, and interest. In Michigan, this can also trigger issues with unemployment and workers’ comp audits.

Some situations are clear. A marketing agency you hire to run your social media is a contractor. The receptionist who works at your office five days a week is an employee. Many situations fall into gray areas though. A specialist who works regular hours but serves multiple businesses could go either way depending on the specifics.

When you’re unsure, look at the relationship honestly. Does this person work only for you? Do you control their schedule? Do you provide their workspace and tools? If yes to most of these, you probably have an employee regardless of what you’d prefer.

Your bookkeeping needs to track employees and contractors separately. Employee wages show up as payroll expense with the associated employer taxes. Contractor payments get recorded as subcontractor or professional services expense and generate 1099 forms at year end. A Metro Detroit bookkeeping service can help you record both correctly so your books stay clean and your tax filings are accurate.