Paying for Work: Payroll and Information Reporting

The moment a business pays anyone for work, it inherits a reporting duty — and the form it files turns on a classification it does not get to choose freely.

Employee or contractor: the classification is not an election. The line is the common-law degree of control — who directs how, when, and where the work is done — not what the parties call it or what the worker prefers ( IRS Pub. 15-A). Direct the work, set the hours, and supply the tools, and the worker is an employee who gets a Form W-2, no matter how convenient a Form 1099 would be. Misclassifying an employee as a contractor to dodge the employer’s half of payroll tax is the single most common — and most aggressively pursued — small-business payroll error: it triggers back FICA and withholding, the IRC §3509 penalties, and state liability on top. A genuine contractor who runs their own business and serves multiple clients gets a 1099 and handles their own self-employment tax.

California runs a stricter test, and it decides state payroll tax too. The federal common-law inquiry is the lenient one. Since AB 5 codified Dynamex in 2020, California presumes a worker is an employee unless the hirer proves all three prongs of the ABC test (Labor Code §2775): the worker is free from the hirer’s control, performs work outside the usual course of the hirer’s business, and is customarily engaged in an independently established trade. Prong B is the one that fails: a software shop paying a contract developer, a clinic paying a contract nurse, an agency paying a contract designer are all buying their own core service. The test governs wage-and-hour law and the Employment Development Department’s payroll-tax audits alike, so a worker who passes the IRS test and fails prong B still generates back state unemployment insurance, disability, and withholding liability. The exemptions — licensed professionals, a bona fide business-to-business contract with its own list of a dozen conditions, and a roster of named occupations — are narrow and documentary. Assume the presumption applies, and paper the exemption before the first invoice.

Paying employees. Collect a Form W-4 at hire, then withhold the employee’s income tax and 7.65% FICA share from each check and remit it with the employer’s matching 7.65%, on the deposit schedule the IRS assigns. File Form 941 each quarter ( Form 944 annually for the smallest employers) and Form 940 annually for federal unemployment tax, and issue each employee a Form W-2 by January 31, transmitting the set to the Social Security Administration on Form W-3. State income-tax withholding and state unemployment (SUTA) run in parallel and must be registered separately.

Seasonal, part-time, and agricultural payroll. The summer hire, the weekend part-timer, and the full-time salaried employee are subject to identical withholding rules — income tax, Social Security, and Medicare. There is no headcount threshold, hours floor, or duration of employment that converts a seasonal worker into a contractor, and “they were only here for July” is not a classification argument. The one accommodation the code does make is administrative: a genuinely seasonal employer need not file Form 941 for quarters in which it paid no wages and so owes nothing. Claim it by checking the “seasonal employer” box in Part 3 of every Form 941 you file; check it consistently and file at least one taxable return for the year, and the IRS generally will not come asking about the empty quarters ( IRS Pub. 15, “Employer’s Tax Guide”, section 12). Simply stop filing without checking the box and those quarters read as delinquent returns, with the failure-to-file notices that follow. Employers of farm workers are on a separate track entirely: Form 943 annually in place of the quarterly 941. The farm rules used to live in their own publication; the IRS stopped revising Pub. 51, “Agricultural Employer’s Tax Guide” after 2023 and folded agricultural employers into IRS Pub. 15, “Employer’s Tax Guide”, so work from Pub. 15 and ignore any advisor still citing Pub. 51.

Paying contractors and vendors: the 1099 web. Collect a Form W-9 before you pay a vendor, so you have a verified taxpayer ID in hand. File Form 1099-NEC for $2,000 or more paid in the year to a non-corporate contractor for services, and Form 1099-MISC for $2,000 or more of rents, prizes, or gross proceeds paid to an attorney — OBBBA raised both thresholds from $600 for payments made after 2025, with inflation indexing thereafter. Most payments to corporations are exempt from 1099 reporting — but legal fees and medical payments are reportable even when the payee is incorporated. The 1099-NEC is due to both the recipient and the IRS by January 31. Payments you make by card or through a third-party platform are reported by the processor on Form 1099-K, so do not also issue a 1099-NEC for them — double-reporting the same income invites a matching notice.

Backup withholding: the price of sloppy paperwork. If a payee refuses a TIN or the IRS flags a name/TIN mismatch, you must withhold 24% of the payment under IRC §3406 and remit it — and if you fail to, the uncollected tax becomes your liability, not the contractor’s. Getting the W-9 before the first check is the entire defense; chasing a missing TIN after year-end is how a business ends up paying a contractor’s tax out of its own pocket.

The penalties scale with delay. Late or incorrect information returns draw penalties under IRC §6721 and IRC §6722 — charged twice, once for the IRS copy and once for the payee copy, and rising the longer the form is overdue, with the cap removed entirely for intentional disregard. File on time even if a figure is imperfect, then correct it; a timely wrong form costs far less than a late right one.