Quick answer

W-2 employees are workers whose employer controls what, how, and when work is done and who receive wages with federal/state tax withholding and employer payroll tax contributions. 1099 independent contractors run an independent trade or business, control how they perform work, receive gross payments (usually reported on Form 1099-NEC), and pay self-employment tax on their net earnings.

This entry explains the IRS tests, practical examples, employer and worker obligations, common pitfalls, and a checklist to reduce misclassification risk.

Why worker classification matters

Classification determines who pays payroll taxes, who gets employee benefits, which forms employers file, and which deductions workers can claim. Employers who treat someone as a contractor but who is actually an employee can face back payroll taxes (employer and employee shares), interest, and penalties; workers misclassified as contractors can lose unemployment, workers’ compensation, and other employee protections (IRS; see the IRS independent contractor guidance: https://www.irs.gov/businesses/small-businesses-self-employed/independent-contractors-employee).

In my practice working with small businesses, I regularly see cost-driven pressure to classify staff as contractors. That short-term saving often creates much larger long-term costs during an IRS audit or state wage claim.

How the IRS decides: the three-factor test

The IRS evaluates worker status based on three broad categories: behavioral control, financial control, and the type of relationship. This framework is summarized on the IRS site and in tax-professional guidance (IRS, “Independent Contractors vs Employees”).

  • Behavioral control (does the company direct or control how the work is done?): specific instructions, required training, or daily oversight point toward employee status.
  • Financial control (are business aspects of the worker’s job controlled by the payer?): an independent contractor typically has unreimbursed business expenses, invests in equipment, and can realize profit or loss.
  • Type of relationship (are there employee benefits, permanency, written contracts?): ongoing pay, benefits, and a job expected to continue favor employee classification.

No single factor is decisive. The entire relationship is weighed.

Key form and filing differences

  • W-2 (Wage and Tax Statement): Employers report wages and withhold federal income tax, Social Security, and Medicare. Employers also remit employer payroll taxes and provide W-2 forms to employees and the SSA (https://www.irs.gov/forms-pubs/about-form-w-2).
  • 1099-NEC (Nonemployee Compensation): Since tax year 2020, nonemployee compensation is reported on Form 1099-NEC (not 1099-MISC). Payers do not withhold income tax; contractors receive gross pay and are responsible for estimated taxes and self-employment tax (https://www.irs.gov/forms-pubs/about-form-1099-nec).

Important deadlines: generally, payers must furnish W-2s and 1099-NECs to recipients by January 31 and file with the SSA/IRS by the same date (electronic filing and deposit rules also apply). Deadlines can change—always verify current IRS guidance each tax year.

For payroll and filing basics, see our internal primer: Payroll Forms 101: Understanding W-2, 1099, and 941.

Common employer mistakes (and how they hurt)

  • Basing classification only on contract wording. A signed contractor agreement does not override the actual working relationship. The IRS looks at facts over labels.
  • Treating a long-term, schedule-driven worker as a contractor to avoid payroll taxes. That triggers employer tax liability, penalties, and possible interest on unpaid amounts.
  • Ignoring state tests. Several states use stricter standards (for example, California’s ABC test under AB5), so classification can differ between federal and state law.

Typical penalties include unpaid employer and employee portions of FICA, FUTA, federal income tax withholding, plus interest and penalties for failure to file and deposit payroll taxes. State penalties and unemployment tax liabilities can also apply.

Real-world examples

  • W-2 employee: A receptionist works on-site five days a week, follows a fixed schedule set by the company, uses company-supplied equipment, receives health insurance through the employer, and cannot subcontract her duties. This worker is almost always an employee and should receive a W-2.

  • 1099 contractor: A graphic designer who maintains a business, works for many clients, sets their own hours, sends invoices, pays business expenses, and is free to hire subcontractors is typically a contractor. They should receive Form 1099-NEC for qualifying payments.

Gray-area example: A remote developer works full-time for one client, follows deliverable deadlines and uses company project management tools. Even with a contractor label, this arrangement often leans toward employee status because of the level of control and exclusivity.

Practical checklist for employers (use annually)

  1. Document the relationship: written engagement letters that describe deliverables, duration, and who controls work methods. Also document facts that support classification (invoices, client lists, insurance).
  2. Evaluate the three IRS factors: behavioral, financial, and relationship. Take notes and retain them with the worker file.
  3. Ask for a Form W-9 from contractors. Keep W-9s on record for payees you treat as contractors. See our guide: Understanding Form W-9, W-2, and 1099: Who Needs Which.
  4. Revisit classification when roles change (hours increase, work becomes ongoing, or the company begins to control work details).
  5. Consider a written contractor agreement that clarifies that the worker is an independent contractor — but don’t rely on it alone.
  6. If exposure is likely (long-term contractor showing employee characteristics), consult a CPA, employment attorney, or consider treating the worker as an employee.

In my experience, documenting the business reasons for classification decisions—rather than simply labeling someone a contractor—reduces risk materially during audits.

What happens if the IRS or state says you misclassified someone?

  • The employer may be assessed back payroll taxes (employer and employee FICA shares), unpaid federal and state unemployment taxes, and interest and penalties for late payment or non-filing.
  • The IRS offers Form SS-8 (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding) that a payer or worker can file to request an official determination; however, processing can take months (https://www.irs.gov/forms-pubs/about-form-ss-8).
  • Some employers use the IRS Voluntary Classification Settlement Program (VCSP) to voluntarily reclassify workers and receive partial relief from payroll tax liabilities (rules and availability change; consult a tax advisor).

Tips for workers

  • Track your hours and client relationships. If you work for one company year-round and follow their policies, you might actually be an employee—even if paid as a contractor.
  • Keep good records of business expenses and consider quarterly estimated tax payments if you receive 1099 income.
  • If you suspect misclassification, you can request a Form W-2 from the payer or contact the IRS or state labor office for guidance.

State laws and the ABC test

Several states use an “ABC test” that makes it harder to label workers as independent contractors. Under the ABC test, a worker is an employee unless the hiring entity shows that (A) the worker is free from control, (B) the work is outside the usual course of the hiring entity’s business, and (C) the worker is customarily engaged in an independently established trade. California’s implementation (AB5) and other state-level rules may impose stricter standards than the federal IRS test—so check state law or consult counsel.

When to get help

If classification is unclear, get professional help. Options include:

  • A tax CPA or payroll specialist to estimate potential payroll tax exposure;
  • An employment attorney for state-law classification risks and defense strategies;
  • Filing Form SS-8 to obtain an IRS determination (note the extended processing time).

Internal resources and next steps

  • For a refresher on the specific payroll forms and filing rules, see our Payroll Forms 101: Understanding W-2, 1099, and 941.
  • For documentation best practices, see Best Practices for Documenting Employee vs Contractor Classification.

Closing practical guidance

Treat classification as a business control, not just a tax checkbox. Review job duties, update contractor agreements when relationships change, and retain documentation showing why you chose employee or contractor status. In my practice, businesses that review classifications quarterly and keep contemporaneous notes substantially reduce audit risk and the stress of retrospective reclassification.

Professional disclaimer

This article is educational and does not constitute legal or tax advice. Worker classification depends on federal and state law and specific facts. Consult a qualified CPA, payroll specialist, or employment attorney for advice tailored to your circumstances.

Authoritative sources

(Internal links: Payroll Forms 101: Understanding W-2, 1099, and 941: https://finhelp.io/glossary/payroll-forms-101-understanding-w-2-1099-and-941/; Choosing Between Form 1099-NEC and W-2: Employee vs Contractor: https://finhelp.io/glossary/choosing-between-form-1099-nec-and-w-2-employee-vs-contractor/; Best Practices for Documenting Employee vs Contractor Classification: https://finhelp.io/glossary/best-practices-for-documenting-employee-vs-contractor-classification/.)