The biggest financial hit is back payroll taxes. When a worker should have been a W-2 employee, you were responsible for withholding income tax and paying the employer’s share of Social Security and Medicare taxes. If the IRS determines you misclassified that worker, you owe both the employer and employee portions of FICA plus penalties and interest on amounts that should have been withheld.

Under Section 3509 of the tax code, if you can show a “reasonable basis” for treating the worker as a contractor, the penalties are reduced. You would owe 1.5% of wages for income tax withholding and 20% of the employee’s share of FICA. Without that reasonable basis, the full amounts apply. And if the IRS determines the misclassification was intentional, the penalties double and criminal charges become a possibility.

Beyond the IRS, Arizona and other state agencies can come after you for unpaid unemployment insurance taxes and workers’ compensation premiums. If a misclassified worker gets hurt on the job and you don’t have workers’ comp coverage for them, you’re personally exposed to the medical costs and liability. That alone can be devastating for a small business.

The trigger for an investigation is often the worker themselves. When someone you’ve been paying as 1099 files for unemployment benefits or gets audited on their own taxes, the state or IRS starts asking questions. A single worker filing Form SS-8 (which asks the IRS to determine their employment status) can open up a review of your entire workforce.

Classification comes down to control. If you dictate when, where, and how someone does their work, provide the tools, and the relationship looks permanent, the IRS is likely to call them an employee regardless of what your contract says. The label on the paperwork doesn’t override the reality of the working relationship.

If you think you’ve been misclassifying workers, the IRS offers the Voluntary Classification Settlement Program. You agree to reclassify workers going forward and pay a reduced penalty covering the most recent tax year. It’s significantly cheaper than getting caught and assessed for multiple years of back taxes and penalties.

The best approach is getting your 1099 preparation right from the start. Understand the rules before you bring on workers, document why each contractor relationship qualifies as independent, and keep records that support your classification decisions.

If you already have contractors and aren’t sure whether they’re properly classified, talk to a small business accounting firm or a tax professional before the IRS makes the decision for you. Fixing a misclassification proactively is always cheaper than defending one after the fact.