1099 vs W-2: how to tell a contractor from an employee, and what it costs to get it wrong

The question sounds like a choice: should I hire this person as a 1099 contractor or a W-2 employee? It isn't, really. Whether someone is a contractor or an employee is decided by how the work actually happens, under tests set by the IRS and by your state. What you call them, and what the contract says, counts for much less than founders expect.

Getting it right matters because the two cost very different amounts and carry very different obligations. Getting it wrong can mean years of back taxes, penalties and wage claims. This guide explains the tests, the costs and what to do if you've already made a mistake.

What each relationship means

A W-2 employee works under your direction. You withhold income tax and their share of Social Security and Medicare, pay your own share, pay unemployment taxes, usually carry workers' compensation, and follow wage and hour laws such as minimum wage and overtime. At year end, you give them a Form W-2.

A 1099 contractor runs their own business. They decide how to do the work, use their own tools, often serve other clients, and pay their own self-employment tax. You pay their invoices without withholding, and if you pay them $2,000 or more for services in a year, for payments made after December 31, 2025, you generally file a Form 1099-NEC.

The federal test: who controls the work?

The IRS uses common-law rules and looks at the whole relationship. It groups the evidence into three categories.

Behavioral control. Do you control, or have the right to control, what the worker does and how they do it? Detailed instructions about when, where and how to work, required training in your methods, and evaluating how the work is done rather than its result all point toward employment.

Financial control. Do you control the business side of the job? A contractor typically invests in their own equipment, has unreimbursed expenses, markets their services to others, is paid by the project, and can make a profit or a loss. An employee is usually paid by the hour, week or month, and has expenses reimbursed.

Type of relationship. How do the two of you treat the arrangement? Employee benefits such as insurance, a pension or paid vacation, an expectation that the work will continue indefinitely, and work that's a key part of your regular business all point toward employment. A written contract helps, but it isn't enough on its own.

No single factor decides it, and the IRS weighs them together. If you're still unsure, either party can ask the IRS to decide by filing Form SS-8, but a decision can take six months or longer.

The stricter state test: California's ABC test

States apply their own tests for state taxes, unemployment insurance and wage laws, and some are much stricter than the IRS. California's is the best known. Under its ABC test, a worker is presumed to be an employee unless the hiring business can show all three of the following:

• A: the worker is free from the business's control and direction in performing the work, both under the contract and in fact,
• B: the work is outside the usual course of the business's own work, and
• C: the worker is customarily engaged in an independently established trade, occupation or business of the same kind.

Part B is the one that catches most businesses. A design agency hiring a freelance designer to do client design work fails it, because design is the agency's usual business, even if the designer has other clients. Several other states use ABC tests for some purposes too, so check the rules where your workers live.

What each costs you

Take a role paid $60,000 a year.

As a W-2 employee, you pay the salary plus:

• your 7.65% share of Social Security and Medicare, $4,590,
• federal unemployment tax, usually $42,
• state unemployment tax at your rate,
• workers' compensation insurance,
• payroll software, and
• any benefits you offer.

As a 1099 contractor, you pay the agreed fee, often at a higher rate than the equivalent salary, because the contractor covers their own self-employment tax, equipment, insurance and benefits. You file a Form 1099-NEC at year end.

The gap is real, at least 8% of pay before benefits, and much more with them. That's exactly why misclassification is tempting, and why regulators look for it.

What misclassification costs

If a worker you treated as a contractor is found to be an employee, the bill can include:

• the federal employment taxes you should have withheld and paid, with interest and penalties,
• state unemployment and payroll taxes,
• workers' compensation exposure for any injuries,
• back wages, such as unpaid overtime, under federal and state wage laws, and
• benefits the worker should have been eligible for.

The cost grows with every year the arrangement continues and every worker it covers. It's the classic small business mistake that's cheap to avoid and expensive to fix.

If you think you've got it wrong

Don't keep the arrangement going and hope. There are better routes.

1. Reclassify going forward. Move the worker onto payroll from a set date. This stops the exposure growing.
2. Consider the IRS Voluntary Classification Settlement Program. If you've consistently treated the workers as contractors and filed all their Forms 1099 for the previous three years, and you're not under an employment tax audit, you can reclassify them for the future and pay 10% of the employment tax liability for the most recent year, calculated at reduced rates, with no interest or penalties on that amount and no audit of prior years' classification for those workers.
3. Get advice on state exposure. The federal program doesn't cover state taxes or wage claims, so talk to an employment attorney or accountant about your state.

Gray areas that trip people up

• A former employee who comes back as a contractor. If they do the same work in the same way, the relationship probably hasn't changed, whatever the new contract says.
• A long-running, part-time contractor. Working part time doesn't make someone a contractor. Someone who works 15 hours a week for you, every week, under your direction, for two years looks like a part-time employee.
• Interns. Unpaid internships at for-profit businesses are tightly limited under federal wage law. Most interns doing real work for a business should be paid as employees.
• Workers from a staffing agency. The agency is usually the employer, which is part of what you pay it for. Check the agreement to confirm who handles payroll taxes and workers' compensation.
• Friends and family helping out. Paying a relative or friend informally doesn't change the rules. If they work under your direction on an ongoing basis, the same tests apply.

When a contractor is the right call

Contractors are the right choice in plenty of situations:

• a defined project with a clear end, such as building a website,
• specialist skills you need occasionally, such as a tax accountant or a lawyer,
• a person who runs an established business and serves many clients, and
• work outside your core business that you don't direct day to day.

In those cases, put a written agreement in place that reflects the reality: the scope or deliverables, the fee, who provides tools, the contractor's right to decide how the work is done, and who owns what they create. Collect a Form W-9 before the first payment. Payroll platforms can handle contractors too: Gusto's contractor-only plan, for example, costs $35 a month plus $6 per contractor.

Contractors abroad

Workers outside the US aren't classified under US employment law in the same way, but the same control questions arise under their own country's rules, and misclassification there carries its own penalties. Our guide to employer of record or contractor covers hiring abroad, and our guide to paying international contractors covers the paperwork.

A quick self-check

Answer these honestly about the role:

1. Do you set their hours or where they work?
2. Do you tell them how to do the work, not only what result you want?
3. Do they use your equipment, accounts and systems?
4. Is the work a core part of what your business sells?
5. Is the arrangement open-ended rather than tied to a project?
6. Do they work only, or mostly, for you?

If you answered yes to several, treat the role as an employee. Our guide to hiring your first employee covers the steps, and our guide to payroll taxes covers the costs.