W-2 vs 1099: how worker classification really works (and why the IRS cares)

W-2 vs 1099: how worker classification really works (and why the IRS cares)

One of the most common and costly mistakes we see in small businesses is worker misclassification. Many business owners assume that if they pay someone as a contractor and issue a 1099, that settles it. Unfortunately, the IRS does not see it that way. Whether a worker should be treated as a W-2 employee or a 1099 contractor depends on how the work relationship actually functions, not what you call it.

At its core, worker classification is about control. The IRS looks at three broad categories: behavioral control, financial control, and the overall relationship between the parties. Behavioral control focuses on whether the business dictates how, when, and where the work is done. If you are setting schedules, requiring specific procedures, or training the worker in your methods, that points toward W-2 employee status.

Financial control examines how the worker is paid and whether they have the opportunity for profit or loss. Contractors typically invoice, set their own rates, provide their own tools, and may work for multiple clients at the same time. Employees are usually paid a regular wage, reimbursed for expenses, and rely on the business for ongoing work. The final factor, the relationship itself, looks at written agreements, benefits, and whether the work performed is a key part of the business’s core operations.

Why does the IRS care so much? Because misclassification often results in unpaid payroll taxes. W-2 employees require the employer to withhold income tax, Social Security, and Medicare, and to pay the employer’s share of payroll taxes. With 1099 contractors, the business avoids those obligations. When workers are incorrectly classified, the IRS views it as lost tax revenue and will assess back taxes, penalties, and interest if discovered.

From a business perspective, the risk is not theoretical. Audits triggered by payroll issues frequently uncover misclassification, and states often have their own enforcement mechanisms layered on top of federal rules. In Wisconsin, we regularly see this issue come up for service-based businesses, especially those trying to keep costs low during early growth stages. For business owners in Green Bay and De Pere, this is an area where getting advice early can prevent years of cleanup later.

Another common misunderstanding is that issuing a 1099 automatically makes someone a contractor. It does not. The 1099 is a reporting form, not a classification tool. If the facts indicate an employee relationship, filing a 1099 does not protect you. In fact, it can make the issue easier for the IRS to identify.

Worker classification also affects the individual performing the work. Contractors pay self-employment tax and often do not realize how large that bill can be until filing season. Employees, on the other hand, have taxes withheld throughout the year and may qualify for benefits and protections that contractors do not receive.

Proper classification should be part of your overall tax preparation strategy, not an afterthought. Reviewing roles, contracts, and workflows annually can help ensure your setup still makes sense as your business evolves. This is especially important when a long-term contractor begins to look more like a core team member.

For businesses in Green Bay and De Pere, working with a local CPA who understands both federal and state rules can make a significant difference. Correct classification supports compliant tax preparation, protects your business from penalties, and gives clarity to everyone involved.

If you are unsure whether your workers are classified correctly, it is far easier and less expensive to fix it proactively than to respond after the IRS comes knocking.