Paying someone as a contractor is easier and cheaper than putting them on payroll: no withholding, no employer taxes, no workers' comp premium, just a check and a 1099 in January. That is exactly why the IRS and state agencies look hard at the choice. If a worker you have been paying as a contractor is really an employee, the back taxes, penalties, and interest land on you, not on them.
The rules are not as vague as owners fear. Here is how the IRS and the states decide, what the decision changes in your bookkeeping, and what to do if you realize you have been getting it wrong.
How the IRS decides: the common-law test
The IRS does not go by what the contract says or what the worker prefers. It looks at the actual working relationship, grouped into three areas. Behavioral control asks whether you direct how the work is done: set hours, required methods, training, step-by-step instructions. Financial control asks whether the worker has a real business of their own: their own tools and equipment, unreimbursed expenses, the chance to make a profit or take a loss, other clients, and payment by the job rather than by the hour. The relationship of the parties looks at written contracts, whether you provide benefits, whether the arrangement is open-ended, and whether the work is a core part of your business.
No single factor decides it, and there is no magic number of factors. The overall picture is what counts. A plumber who runs their own company, brings their own van and tools, bids the job, and works for a dozen other customers is a contractor even if you tell them which day to show up. A helper who works the hours you set, uses your equipment, follows your instructions, and has no other customers is an employee no matter what you call them, and no matter that they asked to be paid on a 1099.
If you genuinely cannot tell, either party can file Form SS-8 and ask the IRS to make the determination. It can take months, and the answer applies going forward, so most owners use it only for a recurring role that will matter for years.
State rules can be stricter
Federal classification is only half of it. State unemployment insurance and workers' compensation agencies apply their own tests, and a number of states use some version of the ABC test, which presumes a worker is an employee unless all three parts are met: the worker is free from your control, the work is outside the usual course of your business, and the worker is customarily engaged in an independently established trade. The second part is the hard one. A restaurant hiring a contract plumber passes it; a restaurant paying a line cook as a contractor does not, because cooking is the restaurant's business.
The federal Department of Labor applies its own economic-reality test for minimum wage and overtime purposes, and the details of that rule have shifted between administrations. The practical point is that a worker can be a contractor under one test and an employee under another, and the strictest test that applies to you is the one that matters. If you operate in a state with an ABC test, treat anyone doing your core work as an employee unless a professional tells you otherwise.
What classification changes in your books
For a contractor, the bookkeeping is light. Collect a Form W-9 before the first payment, record each payment to a contract labor or subcontractor expense account, and in January issue a Form 1099-NEC to anyone paid by check, cash, or bank transfer above the reporting threshold, which is $2,000 for payments made in 2026 and indexed for inflation after that. Payments made by card or through a payment platform are reported by the processor instead. There is no withholding and no employer tax.
For an employee, the business runs payroll. Gross wages go to a wages expense account; the employer's share of Social Security and Medicare, federal and state unemployment tax, and workers' compensation premiums are separate employer expenses; and the amounts withheld from the employee's check are liabilities until they are deposited. Employer Social Security and Medicare alone add 7.65 percent of wages, before unemployment tax and workers' comp, which vary by state and trade. A payroll service handles the calculations, deposits, and quarterly filings, and its reports should be posted to the books every pay period so wages, taxes, and liabilities stay in sync with the bank.
Keep the two groups in separate expense accounts. Mixing contractor payments into wages, or the reverse, makes 1099 prep a reconstruction project and makes the payroll tax returns disagree with the P&L, which is exactly the kind of mismatch that draws a question from the IRS.
If you have been getting it wrong
The cost of misclassification is the employer taxes you should have paid, often a share of the taxes you should have withheld, plus penalties and interest, and in some states back unemployment contributions and workers' comp premiums. Audits are usually triggered by a worker filing for unemployment or workers' comp, or by a complaint, so the exposure grows with every person in the role.
Two relief paths exist. Section 530 relief can protect a business that had a reasonable basis for treating workers as contractors, filed all required 1099s, and treated similar workers consistently. The IRS Voluntary Classification Settlement Program lets an eligible business reclassify workers as employees going forward and pay a reduced amount for the past, generally a small fraction of one year's employment taxes, without interest or penalties. Both come with conditions and paperwork, and a CPA or employment attorney should run the numbers before you file anything.
Clean books make either conversation easier: a clear record of who was paid what, under which account, with a W-9 and 1099 on file for every contractor. That is the standard Evolv Bookkeeping keeps month to month. The service is $199 per month flat: every account reconciled, every transaction categorized, payroll and contractor payments posted to the right accounts, and your P&L and Balance Sheet delivered by day 2 of the following month, with 1099 prep handled at year end. If the books are behind, catch-up is $199 for each month behind, finished within 2 days and guaranteed in writing. No contracts, cancel anytime. Get an instant quote from our homepage.