Startup Payroll Setup: W-2 vs 1099 vs Equity-Only Compensation Done Right
Written by Aparna Devalla, CPA
Curated by Rubric Financial
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The Three Classification Buckets
- W-2 EMPLOYEES: full payroll tax withholding (federal + state + FICA + Medicare), employer pays matching FICA + unemployment + workers comp. Receives W-2 at year-end. Eligible for benefits + ISOs + RSAs.
- 1099 CONTRACTORS: no withholding (contractor responsible for self-employment tax). No employer-side payroll taxes. NOT eligible for benefits + ISOs. Receives 1099-NEC at year-end if >$600 in payments (threshold rises to $2,000 for payments made in 2026 and later).
- EQUITY-ONLY: rare but legal in some contexts (advisors, board members). Receives equity only; no cash compensation. Tax treatment depends on whether equity is options (NSOs for non-employees) or restricted stock.
- MISCLASSIFICATION TRAP: IRS + state agencies aggressively reclassify 1099 contractors as W-2 employees if they fail the 'independent contractor test.' Penalties: 100% of unpaid payroll taxes + interest + state penalties.
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