Misclassifying workers is one of the biggest mistakes a business owner can make. 

It might seem cheaper to pay someone as a 1099 contractor, but if the IRS says they should be a W-2 employee, you’re looking at back taxes, penalties, and possible audits that could cripple your business.

Let’s break down the IRS framework for worker classification, the red flags that trigger audits, and the tax differences between employees and contractors. 

You’ll learn how to protect your business, avoid costly penalties, and even find tax strategies that benefit both employers and contractors.

How Worker Classification Works

The IRS uses a three-part test to decide whether someone is an employee or an independent contractor:

• Behavioral Control – Who decides how the work gets done?
  
  
• Financial Control – Who provides the tools and carries the risk of profit or loss?
  
  
• Relationship – Is there an ongoing commitment, benefits, or a contract that looks like employment?
  
  

If the employer controls most of these factors, the IRS will treat the worker as an employee, even if you have a signed contractor agreement.

Why Misclassification Is So Costly

When the IRS reclassifies a contractor as an employee, you could owe:

• 100% of unpaid payroll taxes (Social Security & Medicare)
  
  
• Federal and state unemployment taxes
  
  
• Penalties and interest on top of back taxes
  
  

For example, paying one worker $50,000 per year as a contractor could result in $7,500 of unpaid FICA taxes annually. Multiply that across three years and ten workers, and the liability can balloon into hundreds of thousands of dollars.

Red Flags That Trigger Audits

The IRS and state agencies typically don’t identify misclassification immediately. But certain events almost always draw their attention. 

❗The two biggest red flags are:

• Unemployment Claims: Independent contractors aren’t eligible for unemployment benefits. If a contractor you’ve let go files a claim, the state will investigate. Once they see that person was paid as a 1099 but worked like an employee, it can trigger a reclassification review and even a broader IRS audit.
  
  
• Disgruntled Workers: Many business owners pay people as contractors without explaining the tax consequences. At tax time, the worker finds out they owe thousands in self-employment taxes because no withholdings were made. That frustration often leads them to their accountant (or directly to the IRS) arguing they should have been treated as an employee.
  
  

Beyond these, other factors can also raise scrutiny:

• Having contractors who only work for you and no one else.
  
  
• Contractors who’ve been with you long-term in roles that look like regular employees.
  
  
• Providing contractors with tools, equipment, or reimbursed expenses.
  
  

Any of these can start a paper trail that results in the IRS or state government digging deeper into your payroll practices.

Tax Treatment: Employee vs Contractor

• Employees (W-2): Employer withholds income, Social Security, and Medicare taxes. Employer also pays half of FICA, unemployment taxes, and issues a W-2.
  
  
• Contractors (1099): Employer issues a 1099, no taxes are withheld. Contractors pay self-employment taxes, file their own returns, and can deduct business expenses.
  
  

The key difference: with employees, the employer carries the tax burden. With contractors, the worker carries the burden but also gets the deductions.

Strategies for Employers

• Review your worker relationships through the IRS 3-factor test.
  
  
• Put strong independent contractor agreements in place if the role qualifies.
  
  
• Avoid long-term arrangements that make contractors look like employees.
  
  
• Understand state rules—California’s AB5 law is stricter than IRS guidelines.
  
  

Strategies for Contractors

If you’re a 1099 worker, treat it like a business from day one:

• Open a separate business bank account.
  
  
• Track expenses for deductions (home office, auto, insurance, travel, meals).
  
  
• Consider retirement plans like a Solo 401(k) or SEP IRA.
  
  
• Once profits reach $50K+, explore S Corp election to reduce self-employment taxes.
  
  

Bottom Line

Classy workers properly from the start. Get it wrong, and the IRS could wipe out years of business growth. 

Listen to the full episode now.

Transcript

[00:00:00] So you just hired your first helper and you're paying them as a 1099 contractor. Smart move, right? You get to save a ton on payroll taxes and avoid all that complex paperwork. But what if I told you that that smart move is actually a massive IRS red flag that could end up costing you tens of thousands in penalties?

[00:00:16] So many business owners walk right into this trap and by the time they realize it. It's too late. The can be absolutely devastating. Seriously, they can end a business before it even gets off the ground. Right now, I'm gonna walk you through the simple framework the IRS uses to classify workers.

[00:00:31] This will help you protect your business and your bank account. Getting this right isn't just about following the rules. It's about building a rock solid foundation for your company's future. We're going to skip the dense legal speak and give you the clear. Actionable info. You need to make the right choice with total confidence.

[00:00:48]

Contractor vs Employee: The Decision and Risks

[00:01:07] Alright, so let's dive into it and let's just talk about this total scenario. If you're looking to bring on a worker for your business, but you're wondering should they be brought on as a contractor, a 1099 contractor or an employee, a W2 employee? And there's big differences between the two, which we're gonna discuss later from.

[00:01:22] How they get taxed, how it's treated on a payroll aspect. But that's a decision that you have to make and if you make the wrong decision, there could be massive IRS and state penalties. You know, misclassifying a worker from a independent, classifying 'em as an independent contractor when they should. Have been a W2 employee can involve back taxes, income taxes, social security, Medicare, FICA taxes.

[00:01:44] It can involve penalties and interest. It can even have some state level fines and audits, especially in California, New York, New Jersey, Massachusetts for unemployment type races.

Case Example: How Costs Add Up

[00:02:00] So let's look at a case example. 'cause I think this will help drive home. This concept. We were working with somebody a couple years ago that hired a freelancer and treated them like an employee without withholding taxes.

[00:02:04] So they're a 1099 contractor, and if the IRS reclassifies them as a W2 employee, you could owe a hundred percent of the unpaid payroll taxes, plus penalties. And now a lot of people might think that's not a big deal. It's like a couple thousand dollars here to the contractor, a couple thousand dollars there.

[00:02:19] But things can start to add up. And in this scenario, let's just say that you were paying somebody $50,000 a year just in FICA taxes alone. That's $7,500 in FICA taxes. Now, if you did this for three years, that's $22,000, 500 in FICA taxes. And if you had 10 workers that you were doing this for, that's $225,000.

[00:02:40] In FICA taxes. And one thing to think about is that's just FICA taxes. That's not factoring in penalties, interest, unemployment, taxes, and anything else. So this little thing, this little piece can start to add up quickly, and I think that's why it's so important that as a business owner.

[00:03:00] We look into this because you might think, oh, $50,000 a year, if I get caught, I'll just pay the $7,500 in FICA plus a little bit of interest in penalties and move on.

[00:03:04] But more often than not, when these cases come up, it's not just one year. They usually don't catch on until year two, year three, year four. And it's usually not just one employee or one worker, but it's multiple workers. It's like $50,000 a year. If you go into just three years, that's $7,500 in just FICA taxes is 22,500.

[00:03:22] Let's say you had 10 people doing that, that's $225,000 again. Without factoring in penalties, interest, unemployment, and those various different things. And so you can tell that if the IRS came after you in year three with 10 workers that you were paying $50,000 a year, that's a massive bill that you'd get stuck with and cause a headache.

[00:03:40] And that's why you can start to see how this could potentially take a business out of business. And we've seen this happen before and I'm hoping that today we can help avoid that.

Audit Red Flags

[00:04:00] So let's talk about some red flags for the audience. What even causes typically. This to raise an audit, what would cause the IRS or a state to start looking at something like this?

[00:04:01] And there's two main that we see and there's, there's multiple, but the two main ones that we see is when you have contractors, 1099 contractors that let, got, let go. Maybe they got that, got laid off for a little bit at a time, certain time period. But then they start to file unemployment and they're, they're not qualified for unemployment because they were 1099.

[00:04:19] Contractors, and that starts to raise a red flag with the state that starts to raise a red flag with the IRS. The other common factor we see is disgruntled employees, and we're gonna talk about the tax consequences of 1099 versus W2, but if you have an employee that you're treating as a 1099 contractor and they don't realize it, they're gonna get to tax season and they're gonna file their taxes and realize that they owe a bunch of taxes because you weren't taking taxes out for them.

[00:04:45] They didn't know what they should have been, and now they get hit with a big tax bill that can cause some frustration. And now their, their, their account might be telling them based on the facts and circumstances, you're, you're an employee. You're not a 1099 contractor, so they should have been treating you as an employee.

[00:04:59] And that can lead to bringing that up to the IRS that can lead to bringing it up to the state government. And so those are the two. Areas where we oftentimes start to see this get flagged again. You have 1099 contractors that got laid off, let go, whatever it might be, and then they file for unemployment, but they don't qualify for unemployment because they weren't employees.

[00:05:17] They were 1099 contractors. Or you have disgruntled or a frustrated employee based on taxes that they weren't expecting, and then they start to report that to the government agencies.

IRS 3-Factor Framework

[00:05:43] So let's talk about the solution. Let's talk about the IRS 3 factor framework. So when the IRS looks at, should it be an independent contractor or should it be an employee, this worker that you're hiring, they look at three main pieces and they look at behavioral control.

[00:05:43] They look at financial control, and then they look at the type of relationship.

[00:06:00] So let's break down each of those. Behavior control is basically just who decides how the work is getting done. For example, if you're telling someone when to show up, what tools to use and how to do it. That's likely falling into that employee territory.

[00:06:01] So behavioral is who decides how the work gets done. Financial control is who invests in equipment, covers the expenses, and can profit or lose from the situation. So as an example, an independent contractor typically is gonna buy their own laptop or their own tools, and they're gonna set their own rate.

[00:06:20] They're gonna come to you and say, here is my rate, and you can either pay it. Or find somebody else. And so those are gonna be typically an independent contractor who invests in equipment, covers expenses, and can show a profit or a loss.

[00:06:36] And the third factor that the IRS looks at is the type of relationship. Is there a written contract? Are there benefits being provided? Is this an ongoing gig or just a one time or a project by project basis?

[00:06:36] And as an example, employees often get health benefits sick days, and it's typically gonna be a long term commitment. This is not somebody that's coming in for a project then leaving, then coming in for another project, then leaving typically there.

Indicators of an Employee

[00:07:00] They're in there on a regular day basis, and so a lot of times it starts to look at control. So to break it down a little bit further, it looks more like an employee relationship if you have control. And so who is controlling that relationship if it's you, the employer? Typically gonna be more of an employee.

[00:07:14] If it's the worker that has more control over the relationship, it's typically gonna be looking, going down that independent contractor route. So if you have control over the day-to-day details of the worker, such as specific instructions, or they're monitored by a supervisor or a boss, typically you're gonna lend it to an employee.

[00:07:31] If you reimburse the worker for expenses that they incurred or you provide tools, equipment, things like that to the worker. Again, typically gonna lead to more of an employee.

[00:07:31] If you determine the price or the rate for that worker. Again, typically gonna lean to more is that employee if you determine when and how much the worker will be working.

[00:07:51] So you're setting the hours, you're setting, where you're setting all these different things. Again, tends to lead to an employee.

[00:08:00] If you have no independent contractor agreement or the worker operates as an individual. So no LLC or company again. Typically going to lean towards the employee side.

[00:08:22] If the worker only does work for you and no one else and intends to work there indefinitely or for a long period of time, again, typically you could be an employee and if you provide benefits or vacation or sick days or those different things, again, typically you can be an employee.

Indicators of an Independent Contractor

[00:08:22] So let's look at it on the flip side. If it would look more like a contractor, if they primarily decide how they're gonna work.

[00:08:45] They primarily decide how much they're going to charge. So they come to you saying, here is my hourly rate. You choose to pay it or not.

[00:08:45] If they work for other companies, typically gonna lean towards independent contractor if they have expenses that they're paying for that you are not reimbursing them for.

[00:09:00] Typically gonna lean towards an independent contractor if they have the possibility of incurring a loss on the job. So again, we look at that profit loss motive. Who has that ability with that profit or loss, if it's typically gonna be land on the contractor. They're gonna be more of a contractor.

[00:09:05] If they bring their own tools and equipment and computer and all those different things. Typically gonna be a contractor.

[00:09:05] And if they work on more of a project by project basis instead of indefinitely or on a regular basis, again, typically gonna be an independent contractor.

Practical Evaluation and Defensibility

[00:09:31] So oftentimes when I'm looking at business owners and talking to them about these workers bringing out, we start to go down those lists, start to look at those different control items that the IRS that's in place, behavior control, financial control, the type of relationship, again, we're looking at who has control.

[00:09:31] In this relationship and start to go through those questions that I just went through and start to tick on a box. You know, take this is an employee, or this is the contractor, and start to see where are some of these check marks being checked off based on your answers to some of those control questions.

[00:09:47] Most of the time it's pretty black and white. I always say, imagine you're sitting across the table from an auditor and you have a worker that you're labeling as an independent contractor. Imagine sitting across from the auditor and trying to defend that.

[00:10:00] And if you can easily do that, I would say yeah, and you can probably list as an independent contractor.

[00:10:06] If everything you're saying and you're describing the relationship, you're describing the work, you're describing everything about that worker and it's sounded more like an employee, guess what? That auditor across the table from you is probably gonna be thinking the same thing.

Contracts vs Working Relationship

[00:10:29] So tip for listeners. If you just have a contract alone, because I get this from a lot of business owners, a lot of times they say I'm an independent contractor agreement, so it's automatically an independent contractor.

[00:10:29] The contract alone will not determine this if you have an independent contractor, but everything else is lining up as an employee, they're gonna be an employee. So the actual working relationship is what matters the most, not just an agreement.

[00:10:49] Now, if you're leaning towards that independent contractor, you're going through those questions, you're leaning towards an independent contractor, then it's important to have.

[00:10:49] A solid independent contractor agreement because that's just gonna help defend it and support it. And the biggest thing that I always say is if you go independent contractor, just make sure your employees or your workers understand what that means. That they're being classified as an independent contractor.

[00:11:04] They're gonna be a business owner. Now they're responsible for withholding taxes and paying estimated tax payments. Make sure that they understand it because remember, one of the triggers to this.

[00:11:19] Is disgruntled employees, and so if you make them aware of it, that's gonna avoid that from the beginning.

State-Specific Rules

[00:11:19] Now, some states have even more strict classifications than just what the IRS has. California as an example, has the AB five law, which can be a little bit more nuanced. It can be a little bit more strict. So just make sure you're also looking into what your state classifications are, as well as what the IRS classifications are.

Tax Treatment: Employees vs Contractors

[00:12:29] Alright, back to this idea of contractors versus employees, and I wanna talk about the tax treatments of each 'cause. This is really what comes into play. So let's first look at an employee.

[00:12:29] What's the tax treatment of an employee? With an employee? You as the employer, withhold taxes. That's income taxes, social security, and Medicare taxes. Those could also be called FICA taxes. You withhold unemployment taxes. That's also part of your job as the employer. When you have an employee at the end of the year, you're gonna issue them a W2 that, which reports all this income that they had, all the taxes that you, that you withheld for them, what that looks like along with any other.

[00:12:56] Benefits from it. And as an employee, you as the employer pay half of Social Security and Medicare. You pay half of FICA taxes, which is a little over seven point half percent. Now the employee will cover the other half, but you're still withholding it for them. So FICA taxes total is around 15%. You as the employer, cover half of that and then you withhold the other half from the employee's pay.

[00:13:18] And oftentimes with an employee, they may get benefits like a 401k health insurance various different benefits that you might offer them as well.

[00:13:37] Now with independent contractors, complete other side of the table. There's no taxes withheld. You don't have to worry about withholding taxes.

[00:13:37] From the payments that you're making to them, you just pay them what they're earned and then they're responsible for that. They pay self-employment taxes on that income. They receive a 1099 at the end of the year, so you're gonna send them a 1099 that shows here's how much we paid them. There's gonna be no withholdings on that. You're just saying, here's how much we paid that contractor. They're gonna be responsible for quarterly estimated taxes.

[00:13:53] They're gonna be responsible for filing that income on their personal tax return. Often that's gonna be a Schedule C. Maybe they're operating as a business. Maybe it's gonna be an S corporation or something like that, but they're responsible for filing their business tax return. And the good thing about that is they can also deduct business expenses against that income that they're earning with you.

[00:14:12] So the key contrast between these two is that employers carry the burden with employees and contractors carry the burden and get the tax deductions. So employers, when you have employees, you're gonna be withholding taxes, you're gonna be sending them into the government agencies, you're gonna be filing payroll tax forms, you're gonna be filing a W2 at the end of the year.

[00:14:30] With contractors. As an employer of a contractor, you're just making their payments and that's it. And you're sending them a 1099 at year end. So that's the black and white difference between the two.

Gray Area: Documentation and Independence

[00:15:00] Now, when we talk about practical steps and there's this kind of gray area, I often tell business owners to go through the different tests and think about control, because oftentimes there can be a gray area and if you decide that if your worker that you have, it's in that gray area and you want to decide to go the contractor route, just ensure that you have strong evidence to support that, have a solid contract in place, have a clear scope of what's being completed, how it's being completed.

[00:15:08] You have an agreement of what's being done. Make sure you have payment terms that are clearly outlined.

[00:15:08] And make sure there's independence there. You remember, you need to have, if you're going that contractor route, you need to have the contractor be in control of that relationship. So check how integrated they are.

[00:15:22] Full-time versus project by project. Be aware of long-term contractors because that can sometimes start to raise a red flag. And the longer and more return or the relationship is the more it starts to look like an employment.

[00:15:44] So if you're in that sort of gray area. Don't worry. Maybe talk to a tax attorney, get a second opinion if you're part of tax el, open up on Ask a Pro, give us the cons.

[00:15:44] Give us the situation of what's going on and we can give you our opinion too. Just make sure that if you decide to go that contractor route, make sure you have enough support. Again, act like you're gonna be sitting across the table from an IRS agent or a state agency agent and explain the situation to them and make sure it sounds like, yeah, they could be on board with it saying this is a contractor.

[00:16:00] Not an employee.

Strategy Impacts for Employers

[00:16:04] Alright, so now let's talk about tax strategies and the first thing I wanna talk about is you as the business owner, let's just say you're a solo business owner. You have no employees, but then you start to bring on employees. The key thing that you wanna remember is that you may start to lose access to some Strat tax strategies like a solo 401k, maybe you're maxing out your solo 401k, and you're doing all these different fun things with your solo 401k because you have no employees.

[00:16:31] Once you start to bring on more regular employees, you're gonna have to do similar things to them. You're gonna have to treat the employees similarly to how you would treat yourself as the owner employee. So you may choose if you're saying, okay, we're gonna hire employees next year, you may choose to do a super high contribution, especially the year before you hire.

[00:16:49] So just make sure that you understand that. As the employer, that once you start to bring your employees, it does limit some of the potential options when it comes to tax strategies, specifically around retirement planning.

Strategies for Contractors

[00:17:00] But now I wanna talk about the tax strategies for you, the worker. Let's say you're a worker and you're listening to this and you are a 1099 contractor.

[00:17:08] I want you to be aware of the power that you have behind you as being a 1099 contractor now that you're a contractor. You're a business owner and you have to treat this like a business, which means that you get access to business deductions. You're gonna take your income, your 1099 income, and then you're gonna be able to take expenses to offset that, and whatever's left over is gonna be considered your profit and you're gonna pay taxes on your profit, not your gross, not.

[00:17:33] Let's show on your 1099. The profit. So that's gonna be your revenue, your 1099 income minus expenses. So think of things like home office, automobile, whether you're using mileage or actual health insurance premiums, taking advantage of travel meals, technology costs, cell phone, internet. Maybe you're setting up a board for this business that you have.

[00:17:52] Maybe you're hiring kids. In that business, whatever it might be, you have a ton of potential to help offset some of that income so that hey, you might have made a hundred thousand dollars in 1099 income, but how can you take money that you were spending anyways, but now find a business purpose for it now that you are a business owner and get a tax deduction for that.

[00:18:10] It also opens up the door to retirement opportunities to put in place. Maybe it's a solo 401k, maybe it's a sep by rate. It opens up the door for you to put more into retirement and different strategies around that. You know, once you have income that hits 50, $60,000 in profit, you might start to look at an S Corp election to save on some of that self-employment taxes that you're gonna be hit with.

[00:18:29] So these are all things that you as a business owner. Are able to now take advantage of and remember, your employer, your worker, the person you're working for is not withholding taxes for you. So make sure you're making estimated tax payments to help make payments against that future tax bill.

[00:18:54] Now, one of the biggest things that I want to say to you as a 1099 worker, treat your independent contractor gig like a business from day one.

[00:18:54] Separate your bank account, have a business bank account for all that income and expenses. Use bookkeeping software to track what type of activ is going on. And number one, and this is why we're here, be proactive about tax planning. The type of strategies that we talk about weekly on our podcast, in our newsletter, on our YouTube channel are all going to start being relevant to you.

[00:19:15] So make sure that you. Start to dig into that tax planning is a super strong possibility for you. Now that you are a business owner, you might be thinking it was W2 and now I'm 1099, so I can't offset that. Or I'm just doing the same thing I was before. But you'd be surprised on how many opportunities there are to take spending that you're gonna do anyways.

[00:19:34] But instead of paying for it, using after tax dollars, we can start to find a business purpose for it and move it into the business to help offset some of that income that we're making.

Recap and Closing

[00:19:55] So making the right choice between a contractor. And an employee isn't just about saving a few bucks on taxes, it's about building a sustainable, protected, and legally sound business from day one.

[00:19:55] It's about managing risk so that you can focus on what you actually do best growing your company.

[00:20:00] To recap, just remember the three care areas of control at the IRS looks at. Behavior control, financial control, and the relationship of the parties. Analyze your working relationships through that lens and you'll be in a much safer position.

[00:20:14] Getting this right from the start is one of the biggest financial decisions that you'll make as a new business owner. It protects your money, it protects your future, and it protects your peace of mind. Knowing that you're doing it right.

[00:20:33] And if you're wrestling with this decision right now, let me know your biggest question in the comments below. Let's protect our businesses together.

[00:20:49] If you want help from our team of tax pros implementing this strategy or questions about this strategy along with every other tax strategy, there's out there possible Visit tax el.com.

[00:20:49] That's TAX. elm.com or click the link into the description for a free discovery call with our team. We are helping business owners like you legally lower your tax bill every single day.

[00:21:00] Thanks for watching, and I'll see you on the next one. I.