1099 contractors vs. employees: the questions the IRS actually asks

Worker misclassification is one of the more expensive mistakes a small business can make, and it is almost always made in good faith. The owner is not trying to dodge payroll tax; they simply describe the arrangement as contracting because that is what it feels like.

The IRS does not care what the arrangement feels like, and it does not care what the contract says either. It applies a common-law test grouped into three categories.

Behavioural control

Does the business have the right to direct how the work is done, not just what result is required? Relevant questions include:

• Do you set the hours and the location?
• Do you specify the sequence of tasks or the methods used?
• Do you provide training on your procedures?
• Is the worker evaluated on how they work, rather than only on the finished result?

Note the phrase right to direct. You do not have to exercise the control. Having the right to exercise it is enough.

Financial control

• Who supplies tools and equipment, and who bears the cost?
• Can the worker realise a profit or suffer a loss on the engagement?
• Are they free to offer their services to other businesses in the same market?
• Are they paid a flat fee per project, or a regular wage regardless of output?

A worker with no unreimbursed expenses, no opportunity for loss, and one client looks like an employee, whatever the invoice header says.

Type of relationship

• Is there a written contract, and does it reflect what actually happens day to day?
• Do they receive employee-type benefits: paid leave, insurance, a retirement plan?
• Is the engagement open-ended or tied to a specific project?
• Are their services a core part of your regular business activity?

That last point carries more weight than owners expect. If you run a roofing company, the person on the roof is very likely an employee.

Documenting your position

If you conclude a worker is genuinely a contractor, build a file that supports it: a signed agreement describing deliverables rather than hours, a valid Form W-9, evidence they carry their own insurance and business licence, invoices they issue on their own letterhead, and evidence of other clients. Keep it all for at least four years.

If you are not sure

Form SS-8 lets you ask the IRS to determine a worker's status. It is slow — typically six months or more — and it does draw attention to the arrangement, so most businesses take a documented position with their CPA instead. Several states, including Arizona, also apply their own tests for unemployment insurance purposes, and a worker can be a contractor federally while being an employee at state level.

How this touches your bookkeeping

Practically speaking: collect the W-9 before the first payment, not the following January. Track payments by payee through the year so the 1099-NEC threshold is not a surprise. Keep contractor payments in an expense account separate from wages. We handle all three as part of standard payables work, and it turns January from a scramble into an export.

None of this is tax or legal advice. Classification disputes are fact-specific — talk to your CPA or an employment attorney about your own arrangements.

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This article is general information for US small business owners and is not tax, legal or accounting advice. Desert Ledger Bookkeeping is not a CPA firm. Speak to a licensed preparer about your own situation.

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