Can You 1099 an Employee? What Employers Need to Know

Many business owners are confused about whether they can issue a Form 1099 to an employee. Correctly classifying individuals as either an employee or an independent contractor is fundamental for tax and legal compliance. The Internal Revenue Service (IRS) provides specific guidelines, and misunderstanding them can lead to significant financial and legal repercussions. Accurate classification directly impacts tax obligations, reporting requirements, and potential liabilities.

Understanding Worker Classification

The distinction between an employee and an independent contractor is not determined by simply labeling the worker or by a signed agreement. The IRS uses a set of common law rules to determine worker status, focusing on the degree of control and independence in the relationship. These rules are grouped into three main categories: behavioral control, financial control, and the type of relationship between the parties. No single factor is decisive, and the totality of the circumstances is considered when making a classification.

Behavioral Control

Behavioral control relates to whether the business has the right to direct or control how the worker performs the task. This includes instructions about when and where to do the work, what tools or equipment to use, and the order or sequence of tasks. Providing training to a worker also indicates behavioral control, as independent contractors use their existing expertise. The more detailed the instructions or the more training provided, the more likely the worker is an employee.

Financial Control

Financial control examines the business aspects of the worker’s job. Key considerations include how the worker is paid, whether expenses are reimbursed, who provides tools and supplies, and whether the worker has the opportunity for profit or loss. An employee is paid a regular wage or salary, while an independent contractor is paid by the job or on commission and may incur unreimbursed business expenses. Independent contractors invest in their own equipment and facilities and can realize a profit or loss from their services.

Type of Relationship

The type of relationship refers to how the parties perceive their relationship and the existence of written contracts, employee benefits, and the permanency of the relationship. A written contract can help clarify the intent of the parties, but it does not override the actual working relationship if it points to an employer-employee dynamic. Providing benefits such as health insurance, pensions, or paid time off indicates an employee relationship. The expectation of an ongoing relationship, rather than a specific project, also suggests an employee status.

Implications of Misclassification

Misclassifying employees as independent contractors can lead to costly consequences for businesses. This error can result in substantial financial liabilities, including unpaid federal and state income tax withholding, Social Security, and Medicare taxes. Businesses are responsible for both the employee and employer portions of Social Security and Medicare taxes (FICA) for employees. If a worker is misclassified, the business may be held liable for these unremitted taxes.

Beyond unpaid taxes, businesses can face penalties and interest. The IRS may assess penalties for failure to withhold income tax, failure to pay Social Security and Medicare taxes, and failure to file correct information returns. These penalties can vary but may include a percentage of the underpaid taxes, and interest accrues on all underpayments.

Misclassification can trigger liabilities for unemployment compensation taxes, both federal (FUTA) and state. Businesses are required to pay FUTA taxes for employees, which fund unemployment benefits. If a worker is misclassified, the business may be retroactively liable for these taxes. Businesses might also face liabilities for workers’ compensation insurance premiums, as independent contractors are not covered by such policies. If a misclassified worker suffers a workplace injury, the business could be solely responsible for related costs not covered by insurance.

Misclassified workers may also seek benefits they were entitled to as employees, such as health insurance, retirement plan contributions, or paid leave. Misclassified workers may also file lawsuits seeking back wages, overtime pay, and other damages under federal laws like the Fair Labor Standards Act (FLSA). Such legal actions can result in judgments against the business, including attorney fees and punitive damages.

Steps to Correct Classification

Businesses should evaluate each worker’s status before engagement to ensure correct classification. A thorough assessment based on the IRS common law factors helps determine whether an individual is an employee or an independent contractor. This initial evaluation can help prevent future compliance issues and potential penalties.

For independent contractors, clear written agreements are important. These contracts should accurately reflect the independent nature of the relationship, outlining the scope of work, payment terms, and the contractor’s independence in performing the services. Such agreements serve as important documentation of the intended relationship, although the actual working relationship remains the primary determinant.

Seeking professional advice from tax professionals, employment attorneys, or human resources specialists is recommended. These experts can provide tailored guidance on worker classification, help interpret complex situations, and ensure compliance with federal and state regulations. Professional consultation helps navigate the nuances of worker classification rules.

If there is uncertainty about a worker’s status, a business or the worker can request a determination from the IRS by filing Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. The IRS will review the facts and circumstances to make an official determination, though this process can take several months. Businesses looking to reclassify workers prospectively can also explore the Voluntary Classification Settlement Program (VCSP). This program offers eligible taxpayers an opportunity to reclassify workers as employees for future tax periods with partial relief from federal employment tax liabilities for past periods. To participate, taxpayers must meet certain eligibility requirements, including consistently treating the workers as nonemployees and filing required Forms 1099 for the previous three years.

Reporting Worker Payments

Once a worker’s status is correctly determined, businesses must adhere to specific IRS reporting requirements for payments made. For individuals properly classified as employees, businesses are required to report wages, tips, and other compensation on Form W-2, Wage and Tax Statement. Employers are responsible for withholding federal income tax, Social Security, and Medicare taxes from employee wages and remitting these amounts to the appropriate tax authorities.

For independent contractors, payments are reported differently. Businesses must report payments of $600 or more made during the calendar year for services performed in their trade or business on Form 1099-NEC, Nonemployee Compensation. Unlike employees, businesses do not withhold income, Social Security, or Medicare taxes from payments made to independent contractors. The independent contractor is responsible for paying their own self-employment taxes, which cover Social Security and Medicare contributions.