Getting this wrong is one of the most expensive mistakes a small business makes. Call someone a 1099 contractor when the IRS would call them a W-2 employee and you can owe back payroll taxes, interest, and penalties on every dollar you paid them. This guide walks the actual federal test and the steps to classify correctly.
Education only, not tax or legal advice. The right answer depends on your specific facts. Confirm with a CPA or employment attorney before you decide.
W-2 employee. You withhold income tax, withhold the employee's half of Social Security and Medicare, and pay a matching employer share of 7.65 percent (6.2% Social Security + 1.45% Medicare). You also typically owe federal and state unemployment tax, follow wage-and-hour law, and may provide benefits. You report wages on a Form W-2.
1099 contractor. You pay an agreed amount, withhold nothing, and pay no employer payroll tax. The contractor covers their own self-employment tax of 15.3 percent (the full 12.4% Social Security + 2.9% Medicare, since they are both employer and employee). For tax year 2025 you report payments of 600 USD or more for services on a Form 1099-NEC.
The cost gap is why misclassification is tempting and why the IRS scrutinizes it. The label you put on the relationship does not control. The facts do.
The IRS does not use a single rule. It weighs the degree of control and independence across three categories, considering all facts together. No single factor is decisive.
Does the business control, or have the right to control, what the worker does and how they do it? Indicators of an employee: you set their hours, require specific methods, provide detailed instructions, or train them in your procedures. A contractor decides how to deliver the result.
Does the business control the financial side of the job? Indicators of a contractor: they have a significant investment in their own tools/equipment, they have unreimbursed business expenses, they can realize a profit or loss, and they make their services available to the broader market. An employee is generally guaranteed a regular wage and uses your equipment.
What do the parties believe the relationship is? Factors: written contracts, whether you provide employee-type benefits (insurance, pension, paid vacation), the permanency of the relationship, and whether the work is a key, ongoing part of your core business. Indefinite, central-to-the-business work points toward employee.
If the IRS reclassifies a contractor as an employee, you can become liable for the employment taxes you should have withheld and paid, plus interest and penalties. Mitigation paths exist, including Section 530 relief (which requires a reasonable basis, consistent treatment, and that you filed the required 1099s) and the Voluntary Classification Settlement Program. Recent IRS guidance (Rev. Proc. 2025-10 and related) clarified and in some respects narrowed Section 530 eligibility, which is another reason to verify current rules with a professional rather than assuming the old standard still applies. Workers who believe they were misclassified can report their share of uncollected Social Security and Medicare tax on Form 8919, which puts the issue on the IRS's radar.
The safest posture for a growing business: classify conservatively, paper the relationship, and never let the tax savings of a 1099 drive a decision the facts do not support.