Why This Matters: The IRS Takes Misclassification Seriously
When you misclassify an employee as an independent contractor, you avoid payroll taxes — employer Social Security, Medicare, and FUTA. The IRS knows this and specifically audits for it. If the IRS reclassifies your 1099 workers as employees, you can owe back payroll taxes, interest, and penalties going back three years — or six if the IRS finds the misclassification was intentional.
The Department of Labor also enforces misclassification rules independently, with separate penalties and back-wage requirements under the Fair Labor Standards Act.
This is not a gray area where “everyone does it.” It’s one of the IRS’s most productive audit targets.
The IRS Common Law Test
The IRS uses a multi-factor analysis based on three broad categories of control:
1. Behavioral Control
Does the company control how the worker does the job — not just the result, but the method?
- Does the company provide training on how to do the work? (Employee indicator)
- Does the company dictate when, where, and how the work is done? (Employee indicator)
- Does the worker use their own methods and tools? (Contractor indicator)
2. Financial Control
Does the company control the business aspects of the worker’s job?
- Is the worker paid a fixed wage or salary regardless of hours? (Employee indicator)
- Does the company reimburse expenses? (Employee indicator)
- Does the worker have a significant investment in their own tools/facilities? (Contractor indicator)
- Can the worker profit or lose money based on how they manage the work? (Contractor indicator)
- Does the worker offer services to the general market? (Contractor indicator)
3. Type of Relationship
- Is there a written contract? (Contractor language helps but doesn’t control)
- Does the company provide employee benefits (insurance, pension, vacation pay)? (Employee indicator)
- Is the relationship permanent or indefinite? (Employee indicator)
- Is the work a key aspect of the company’s regular business? (Employee indicator)
The ABC Test (Used by Many States)
Many states — including Washington — use a stricter standard called the ABC test, particularly for wage and hour purposes. Under this test, a worker is an employee unless ALL THREE of the following are true:
- A: The worker is free from control and direction in performing the work
- B: The work is performed outside the usual course of the hiring business, or outside all places of business
- C: The worker is customarily engaged in an independently established trade, occupation, or business
Washington state uses the ABC test for purposes of the Washington Industrial Insurance Act (workers’ comp) and unemployment insurance. If a worker fails any prong, they are an employee for state purposes — even if the IRS would classify them as a contractor.
Real-World Scenarios
| Situation | Likely Classification | Why |
|---|---|---|
| Graphic designer who works for multiple clients, sets their own hours, uses their own equipment | Contractor | Passes behavioral, financial, relationship tests |
| Full-time worker doing the company’s core work, on a set schedule, with company tools — paid via 1099 | Employee | Control over method and schedule, integral to business |
| IT consultant on a 6-month project, works with other clients, invoices by the hour | Probably contractor | Defined scope, independent operation — but check state rules |
| Delivery driver classified as contractor by gig platform | Contested — state-dependent | Many states are reclassifying gig workers under ABC test |
If You’re Already Misclassifying: Section 530 Relief
If you’ve been misclassifying workers but can show you had a reasonable basis for doing so (industry practice, a prior IRS audit that didn’t raise the issue, or a court case), you may qualify for Section 530 relief — which allows you to avoid back payroll taxes even if the workers are reclassified. The conditions are specific and the documentation requirements are strict.
The Bookkeeping Angle
Misclassification has bookkeeping consequences beyond the payroll tax exposure. If workers are reclassified, their compensation moves from “contract labor” (Schedule C expense) to “payroll” — a different line with different tax treatment, different reporting, and different accounts on the balance sheet (payroll liabilities). If you have 1099 contractors who should be employees, this affects your P&L, your balance sheet, your payroll tax deposits, and your state reporting.
It’s also worth noting: if you’re paying people as contractors who should be employees, your books likely aren’t set up to track payroll liabilities correctly. That’s something a Bookkeeping Diagnostic will catch.