Independent Contractor or Employee? How the IRS Decides
Paying workers as contractors on a 1099 saves payroll taxes, but only if they really are contractors. Getting it wrong can cost back taxes, penalties and interest. Here's how the IRS looks at it.
By the Enrolled Agents and CPAs at A&W Tax Services · Updated
It's about control, not the paperwork
A signed contractor agreement or a 1099 doesn't make someone a contractor. The IRS looks at the whole relationship, and the key question is whether you control what work is done and how it's done, or only the result.
The three categories the IRS looks at
- Behavioral control: do you set the hours, give detailed instructions, train them and decide how the work is done?
- Financial control: do they invest in their own tools, have the chance of profit or loss, work for other clients and send invoices?
- Relationship: is there a written contract, are benefits provided, is the work ongoing, and is it a core part of your business?
The cost of misclassification
If the IRS reclassifies a worker as an employee, the business can owe the income tax it should have withheld, both halves of Social Security and Medicare, federal unemployment tax, and penalties and interest. The Texas Workforce Commission applies its own test for state unemployment tax and can assess back tax too.
If you're not sure
- Write down how the work is actually done and compare it with the three categories
- Either party can ask the IRS for a determination on Form SS-8, though it takes months
- The IRS Voluntary Classification Settlement Program lets eligible businesses reclassify workers going forward with reduced back payroll tax
- Treat workers consistently. Similar workers should be classified the same way
If they are contractors
Collect a Form W-9 before you pay, and file Form 1099-NEC by January 31 for each contractor you paid above the IRS reporting threshold. Keep invoices and contracts on file. If you're adding employees, set up payroll before the first paycheck, not after.