1099 vs W-2. When you can use a contractor, when you must hire an employee.
You cannot make someone a 1099 contractor just by calling them one. Worker classification depends on the actual nature of the working relationship, not the label. This guide covers the IRS three-factor test, the state-specific ABC test that applies in California and many other states, and the penalties for getting it wrong (back wages, back taxes, penalties, class action exposure).
Start here.
Worker under your direction and control. You set hours, location, methods, tools. You handle tax withholding, FICA matching, unemployment insurance, workers comp.
Independent business operator. They control how, when, where work happens. They have multiple clients, use own tools, set own hours. You pay them, they handle their own taxes.
Behavioral control, financial control, relationship type. No single factor controls; the totality of the relationship determines classification.
Used by California (AB5), Massachusetts, New Jersey, and others. Worker is presumed employee unless ALL three: (A) free from control, (B) work outside usual business, (C) engaged in independent trade.
Back wages, back FICA, back unemployment, back workers comp, plus penalties (often 100%+ of original obligation), plus interest, plus class action exposure.
The full explanation.
IRS three-factor test
(1) Behavioral control: Does the company direct or control how the worker does the job? (Schedule, location, tools, training, methods.) More control = more likely employee. (2) Financial control: Does the company control business aspects? (Reimbursement of expenses, equipment investment, opportunity for profit or loss, services available to market.) Worker bearing business risk = more likely contractor. (3) Relationship type: Written contracts, employee-style benefits, permanency of relationship, services key to business operations.
ABC test (California AB5 and other states)
Stricter than IRS test. Worker is an employee unless ALL THREE: (A) Worker is free from control and direction in performing the work. (B) Worker performs work OUTSIDE the usual course of hiring entity's business. (C) Worker is engaged in an independently established trade, occupation, or business. (B) is the hardest to satisfy: a graphic designer hired by a graphic design firm fails (B).
California AB5 exemptions
AB5 exempts specific professions: doctors, lawyers, accountants, real estate agents, financial advisors, marketing consultants, graphic designers (with conditions), and others. Each exemption has specific tests. Outside exemptions, ABC test applies strictly.
Misclassification penalties - federal
IRS: back FICA (employer + employee shares = 15.3%), back income tax withholding, failure-to-deposit penalty (2-15%), failure-to-file penalty, plus interest. DOL: back wages including overtime, liquidated damages (often equal to back wages).
Misclassification penalties - state
Each state has its own penalties. California: $5,000-$25,000 per misclassified worker plus back wages, plus willful violation criminal penalties. Other ABC-test states similar.
1099-NEC threshold
You must issue Form 1099-NEC to any contractor paid $600+ in a calendar year. Form 1096 transmittal accompanies paper filing. Both due to IRS by January 31.
Independent contractor agreement
Written agreement clarifies intent but does not control classification. Should include: scope of work, deliverables, payment terms, IP assignment, confidentiality, independent contractor status acknowledgment, no benefits/no employee rights waiver. Our templates cover the essentials.
Reclassification options
Voluntary Classification Settlement Program (VCSP): IRS program letting employers reclassify with reduced penalties if certain conditions met. Section 530 safe harbor: protects from federal employment tax liability if (a) reasonable basis for treating worker as contractor, (b) consistent treatment of similar workers, (c) all 1099-NEC forms filed.
Common questions.
Can I make a worker 1099 just to save FICA?
What is the difference in cost between W-2 and 1099?
Are gig workers 1099 or W-2?
Can I have someone work full-time and still be 1099?
What about international contractors?
What if I am wrong about classification?
Do I withhold tax from 1099 payments?
What about 1099-MISC vs 1099-NEC?
Can my LLC be a 1099 contractor?
Tax setup, done right.
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This guide is educational. Specific situations require professional advice from a licensed CPA or tax attorney.
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