What Small Businesses Get Wrong About W-2s and 1099s

For small business owners, few administrative decisions carry as much long-term impact as how you classify the people who work for you. Whether someone should receive a W-2 as an employee or a 1099 as an independent contractor is a question that often causes confusion—and, unfortunately, leads to costly mistakes.

Misclassification can result in back taxes, penalties, interest, and even audits from the IRS or Department of Labor. In recent years, both federal and state agencies have increased scrutiny around worker classification, particularly in the gig economy and among small businesses that rely on flexible labor.

Here’s what small businesses often get wrong about W-2s and 1099s—and how to avoid missteps that could put your company at risk.

1. It’s Not About What You Call Them—It’s About How They Work

One of the most common misconceptions is that issuing a 1099 form automatically makes someone an independent contractor. In reality, the IRS looks at the substance of the relationship, not the label.

The IRS uses three main categories to assess worker status:

• Behavioral control: Do you direct how the work is done? Set hours, require specific tools, or closely supervise the worker?

• Financial control: Do you reimburse expenses, provide steady pay, or restrict the worker’s ability to offer services to others?

• Type of relationship: Is there a written contract? Are benefits offered? Is the relationship long-term or project-based?

If the employer exercises significant control in these areas, the worker likely qualifies as an employee (W-2)—regardless of what form is issued.

2. Independent Contractors Have True Business Autonomy

Independent contractors are self-employed individuals running their own business. They typically:

• Work with multiple clients

• Set their own rates and hours

• Use their own tools or software

• Invoice for their services

• Accept the risk of profit or loss

If you’re dictating day-to-day details or restricting these freedoms, the IRS may not consider the relationship to be truly independent.

3. Misclassification Isn’t Just an IRS Issue

While the IRS may impose federal payroll tax penalties for misclassification, you may also face consequences at the state level. Many states have their own criteria for defining employees versus independent contractors. Some, like California and Massachusetts, apply stricter tests—such as the ABC Test—to determine status.

Additionally, misclassification can lead to:

• Unpaid workers’ compensation or unemployment insurance

• Back wages or overtime pay under the Fair Labor Standards Act (FLSA)

• Legal liability if a contractor files a claim for benefits or protections owed only to employees

4. A Contract Alone Doesn’t Determine Status

While a contractor agreement is a best practice—and may be helpful in legal disputes—it doesn't override IRS or state standards. Agencies will examine the real nature of the working relationship.

In other words, calling someone an independent contractor in a contract won’t protect your business if they functionally operate as an employee.

5. Form Filing Requirements Are Strict—and Time-Sensitive

Beyond classification, many small businesses fall short on filing and deadline requirements for both W-2s and 1099s.

W-2s (Employees):

• Must be provided to employees by January 31

• Filed with the Social Security Administration (SSA)

• Include withheld income tax, Social Security, and Medicare contributions

1099-NEC (Nonemployee Compensation):

• Used to report payments of $600 or more to independent contractors

• Also due January 31

• Filed with the IRS, and in some cases, with state agencies

Failure to meet these deadlines can result in penalties ranging from $60 to $310 per form, depending on how late the filing is.

6. You May Need to Reevaluate Long-Term Contractor Relationships

A common scenario: A small business hires a contractor for an initial project, but the relationship extends for months—or even years—with regular weekly work. Over time, this can begin to resemble a traditional employment arrangement.

If the nature of the work or control over the worker has evolved, it may be time to reassess their status to stay in compliance.

Best Practices for Small Business Owners

To avoid costly mistakes and protect both your business and your workers:

• Review classification criteria annually, especially for long-term contractors

• Consult the IRS Form SS-8 if you're unsure about a worker’s status

• Maintain detailed contracts and documentation outlining the scope of work

• Work with a CPA, tax advisor, or HR consultant familiar with local labor laws

• Use payroll software that helps manage both W-2 and 1099 compliance

Final Thoughts

Worker classification isn’t just a box to check during tax season—it’s a critical compliance issue that affects payroll, benefits, taxes, and legal liability. The good news? With the right knowledge and processes, small businesses can confidently navigate W-2s and 1099s and build fair, compliant relationships with everyone they work with.

Disclaimer: This article is for informational purposes only and does not constitute legal, tax, or financial advice. For guidance specific to your business, consult a qualified advisor or legal professional.