Quick answer

Employers must classify each worker as either an employee or an independent contractor based on the degree of control and the working relationship. Employees get a W-2; independent contractors who receive $600 or more for services in a year generally get a 1099-NEC. Classification determines who withholds and pays payroll taxes, which forms to file, and the deadlines to meet (IRS guidance: https://www.irs.gov/businesses/small-businesses-self-employed/independent-contractor-self-employed-or-employee).

Why proper classification matters

Misclassifying a worker can trigger back taxes, penalties, interest, and state-level fines. Employers who treat employees as contractors may avoid payroll taxes short term but face audits and liability later. Correct classification protects your business and the worker’s benefit rights.

The legal test — what the IRS looks at

The IRS uses three broad categories to evaluate classification:

  • Behavioral control: Who directs when, where and how the work is done? If the payer controls these details, the worker is likely an employee.
  • Financial control: Who controls business aspects such as unreimbursed expenses, investment in tools, and the opportunity for profit or loss? Greater financial independence leans toward contractor status.
  • Type of relationship: Written contracts, employee benefits, permanence of the relationship, and the services’ centrality to the business influence the classification.

These factors are described in the IRS common-law rules (see IRS: “Independent Contractor (Self‑Employed) or Employee?”). No single factor is decisive; the total relationship is reviewed (https://www.irs.gov/businesses/small-businesses-self-employed/independent-contractor-self-employed-or-employee).

Practical classification checklist for employers

  1. Ask for Form W-9 (contractor) or Form W-4 (employee) before paying the worker. Keep the completed form on file.
  2. Review contracts and daily workflow. Does your business set schedules, require training, or supervise tasks closely? If yes, employee status is likely.
  3. Consider the permanence and regularity of the work. Ongoing, exclusive relationships often indicate employment.
  4. Evaluate who supplies tools and covers expenses. Contractors usually provide their own equipment and absorb business costs.
  5. When in doubt, document your rationale and consult a CPA or employment attorney.

For more details on forming this analysis, consult our deeper guide: W-2 vs 1099: Determining Proper Worker Classification.

Forms, thresholds and deadlines (current guidance)

  • Form W-2: Employers must provide a W-2 to each employee by January 31 and file with the Social Security Administration by the same date (see About Form W-2: https://www.irs.gov/forms-pubs/about-form-w-2).

  • Form 1099-NEC: Use this form to report nonemployee compensation of $600 or more. Issue to the recipient and file with the IRS by January 31 (see About Form 1099-NEC: https://www.irs.gov/forms-pubs/about-form-1099-nec).

  • Other 1099s (e.g., 1099-MISC): Report other types of payments (rents, prizes, attorney payments) on the appropriate 1099. Deadlines can differ: recipient copies are due by January 31. IRS filing dates vary by form and whether you file electronically—refer to the General Instructions for Certain Information Returns.

An employer-focused overview of the common information returns appears in our guide: Employer Reporting Basics: W-2 vs 1099-MISC vs 1099-NEC.

Payroll tax responsibilities when you classify an employee

When a worker is an employee you must:

  • Withhold federal income tax, Social Security tax (employee portion), and Medicare tax from wages.
  • Match the Social Security and Medicare taxes (employer share) and deposit both employee and employer shares according to IRS deposit schedules.
  • Pay federal (and usually state) unemployment taxes and file relevant returns.
  • Report wages and withheld taxes on Form W-2 and file returns such as Form 941 (quarterly) or Form 944 (annual) as applicable.

The IRS provides employer guidance in Circular E/Publication 15 for withholding and deposit rules (see IRS Employer’s Tax Guide). State payroll obligations may add requirements; check state agencies for unemployment tax rates, wage withholding, and workers’ compensation rules.

What to issue to independent contractors

Independent contractors receive Form 1099-NEC for nonemployee compensation of $600 or more. You do not generally withhold federal income tax, Social Security, or Medicare for contractors.

Contractors are responsible for reporting their income and paying self-employment tax and estimated tax payments. Businesses should still collect a completed Form W-9 to verify the contractor’s taxpayer identification number and legal name.

Common mistakes and how to fix them

  • Paying contractors like employees: Treating a worker as a contractor while controlling hours and work methods increases audit risk.
  • Missing or incorrect TINs: File Form 1099 with the correct TIN. If you receive a B‑Notices or incorrect TIN, address it promptly to avoid backup withholding obligations.
  • Late filings: Deadlines are strict. Late or missing forms can trigger penalties. Use the IRS portal or an authorized e-file provider to reduce filing errors.

If you realize you filed the wrong form, correct it quickly. Guidance for correcting W-2s and 1099s is available from the IRS and in our article on corrections: Correcting W-2 and 1099 Errors Without an Audit.

Penalties and potential liabilities

Penalties depend on how late the return is filed and whether the error was intentional. If the IRS finds misclassification, employers may owe back payroll taxes, interest, penalties, and possibly state assessments. In some cases, the IRS can assess the worker and employer shares as a trust fund recovery penalty against responsible individuals.

For information-return penalty details, see the IRS General Instructions and our article on avoiding fines: Information Return Penalties: How to Avoid 1099 and W-2 Filing Fines.

State rules and special cases

States often have independent rules or tests (for example, California’s ABC test). A worker can be an independent contractor under federal rules but an employee under state law. Confirm state unemployment and labor departments’ guidance for compliance.

Special categories such as statutory employees, household employees, and certain direct sellers have distinct reporting rules. Review IRS guidance or consult a tax professional for those exceptions.

Corrective actions if you misclassified a worker

  1. Reclassify the worker and issue corrected information returns (W-2, 941 adjustments).
  2. File Form 941-X to correct withheld and reported taxes for affected quarters.
  3. Consider voluntary disclosure programs or the IRS’s Form SS-8 if classification is uncertain; Form SS-8 asks the IRS to determine worker status but can take months to resolve.
  4. Keep documentation of your classification analysis and any corrective steps.

Real-world scenarios (short illustrations)

  • A small retailer treated a long-term seamstress as a contractor but controlled her schedule and provided supplies; an audit required the retailer to pay back payroll taxes and penalties. After reclassification, the business adjusted payroll and issued W-2s.

  • A tech startup used short-term freelance programmers who controlled their hours, worked for multiple clients, and accepted project-based fees. The company obtained W-9s and issued 1099-NECs when payments exceeded $600.

Both examples show documentation and intent matter—treat each relationship individually.

Action plan for employers (next steps)

  • Create a standard intake packet: Form W-9, contract template, and internal checklist.
  • Train hiring managers on classification indicators.
  • Use written contracts that reflect the actual working relationship—not to alter classification merely on paper.
  • Consult a CPA or employment lawyer before making systemic classification decisions.

Useful IRS resources

Professional disclaimer

This content is educational and does not constitute legal or tax advice. Employer reporting rules are fact‑specific and can change. For personalized guidance, consult a licensed CPA, tax attorney, or your state labor agency.

If you need a downloadable checklist or sample intake forms, our guides on worker classification and information-return corrections can help—see the internal resources linked above.