Mastering 1099s and W-2s: year-end payroll tax basics

December arrives. You've paid employees and contractors throughout 2025—now the IRS expects documentation. By January 31, 2026, you must furnish W-2s to employees and 1099-NEC forms to contractors. Miss that deadline and penalties start at $50 per form, escalating to $290 if you ignore it entirely.

But timing isn't the only risk. Send the wrong form to the wrong worker and you've triggered audits, back taxes, and legal complications. The IRS has intensified worker misclassification enforcement, hiring additional auditors specifically to catch firms that blur the employee-contractor line.

A law firm with 15 employees and 8 contractors faces $6,670 in penalties for missing deadlines completely. Add misclassification penalties—back payroll taxes, interest, and worker claims—and a paperwork mistake becomes a five-figure problem.

The solution: Master three fundamentals. Understand what each form reports and why classification determines which form to use. Collect documentation systematically before December chaos hits. Meet filing deadlines while knowing how to handle corrections when mistakes happen.

Understand the difference (classification is not optional)

Choosing between a W-2 and 1099-NEC isn't preference. It's a legal determination based on the working relationship. Get it wrong and consequences compound.

W-2s vs 1099-NEC: What Each Form Reports

A W-2 reports compensation paid to employees—people who work under your direction. You control their schedule, provide tools and training, and withhold federal income tax, Social Security, and Medicare. The W-2 documents what you paid and what you withheld.

A 1099-NEC reports payments to independent contractors who control their own work methods, schedule, and tools. You pay them the agreed amount without withholding. They handle their own taxes, including the full 15.3% self-employment tax burden.

The distinction matters: Employees get benefits, protections, and tax withholding. Contractors get none of that. Your obligations differ dramatically.

Important: The 1099-NEC replaced the old 1099-MISC (Box 7) for contractor payments starting in 2020. For services rendered in 2025, you'll use 1099-NEC.

The $600 Rule and When 1099s Become Required

You must issue a 1099-NEC to any contractor or sole proprietor you paid $600 or more during the year for services. That's total aggregate payments, not per project.

Examples:

• Paid a graphic designer $400 in March and $450 in October? That's $850 total—you owe them a 1099-NEC.

• Paid a freelance attorney $2,000 for a single project? You owe them a 1099-NEC.

Key exceptions:

1. Payments to corporations: Generally don't require 1099s (though some firms issue them for tracking)

2. Credit card or payment processor transactions: These trigger 1099-K forms issued by the processor, not you (more on this in our guide to navigating 1099-K rules)

3. Payments for products: 1099-NEC covers services, not merchandise

How the IRS Decides Who's an Employee vs Contractor

The IRS uses a three-factor test: behavioral control, financial control, and relationship factors.

1. Behavioral Control: Do You Direct How Work Gets Done?

Employees:

• Follow your detailed instructions and processes

• Receive training from you

• Work set hours you determine

• Use your methods for completing work

Contractors:

• Decide their own methods

• Use their own expertise without your training

• Set their own schedule within project deadlines

• Apply their own processes

Industry examples:

• Law firm: A paralegal who works 9-5 in your office, uses your case management system, and follows your procedures is an employee. A contract attorney who handles overflow work from their own office using their own research tools is a contractor.

• Healthcare practice: A medical assistant on your payroll working set shifts is an employee. A locum tenens physician covering temporary gaps with their own malpractice insurance is a contractor.

• Creative agency: A staff designer attending daily standups and using your Figma templates is an employee. A freelance illustrator delivering finished artwork on project deadlines is a contractor.

2. Financial Control: Who Bears Business Risk?

Employees:

• Use your equipment and software

• Get reimbursed for expenses

• Receive steady paychecks regardless of outcomes

• Work primarily or exclusively for you

Contractors:

• Invest in their own tools and licenses

• Absorb their own business expenses

• Can profit or lose based on project efficiency

• Serve multiple clients simultaneously

Industry examples:

• IT services: A salaried developer using your equipment and working 40 hours weekly is an employee. A specialized consultant who brings their own development environment and serves multiple clients is a contractor.

• Nonprofit: A program coordinator on staff managing daily operations is an employee. A grant writer hired for a specific proposal, working from their office with multiple nonprofit clients, is a contractor.

3. Relationship Factors: How Do Both Parties View This?

Employees:

• Written employment agreements with ongoing terms

• Receive benefits (health insurance, PTO, retirement)

• Expect indefinite work continuation

• Perform core business functions

Contractors:

• Project-based contracts with defined deliverables

• No benefits beyond service payment

• Expect work to end when projects complete

• Perform specialized or supplemental functions

The gray area: Many professional service firms struggle with long-term specialists. A fractional CFO working 20 hours weekly, attending leadership meetings, using your financial software, and serving few other clients starts resembling an employee—regardless of what your contract says.

What Misclassification Actually Costs

When the IRS reclassifies a contractor as an employee retroactively, you owe:

1. Back payroll taxes:

• Your share of Social Security tax (6.2% of wages)

• Your share of Medicare tax (1.45% of wages)

• Federal unemployment tax (FUTA, typically 0.6% of first $7,000)

• State unemployment tax (varies, often 2-5%)

Example: You paid a "contractor" $50,000 over two years. The IRS reclassifies them. You suddenly owe approximately $7,650 in back employer payroll taxes, plus interest.

2. Failure-to-withhold penalties: The IRS assesses penalties for not withholding the employee's share of taxes from paychecks.

3. Failure-to-file penalties: $290 per form if you filed 1099s when you should have filed W-2s.

4. Interest compounding from when taxes should have been paid (currently 7-8% annually).

5. State-level consequences: Back unemployment insurance, workers' compensation premiums, and state-specific penalties (some states add 25-100% penalties).

6. Worker claims: Misclassified workers can file for unemployment benefits, workers' compensation, denied employee benefits, and overtime pay.

Total cost example: A healthcare practice with 3 misclassified contractors averaging $45,000 annually over 2 years faces approximately $41,000 in back taxes, penalties, and interest—before any worker claims.

Collect the Right Information Early—Before Year-End Panic Sets In

Accurate forms require accurate data. Firms that handle year-end filing smoothly collect information systematically throughout the year.

What You Need for W-2s

To generate a W-2:

• Employee's legal name (exactly as on Social Security card)

• Social Security Number (SSN)

• Current mailing address

• Total wages, bonuses, and tips

• Federal income tax withheld

• Social Security wages and tax withheld

• Medicare wages and tax withheld

• State wages and tax withheld (if applicable)

Your payroll system (Gusto, ADP, Paychex, QuickBooks Payroll) captures this automatically. W-2 generation summarizes every paycheck.

Common problems to fix now:

1. Incorrect SSN: The #1 cause of W-2 rejection. Verify SSNs match Social Security cards.

2. Wrong addresses: Employees who moved need updated addresses.

3. Name mismatches: "Bob Johnson" in payroll vs "Robert L. Johnson" on Social Security card causes rejections.

Action: Run a payroll exception report in early December showing missing SSNs, mismatched names, or stale addresses.

What You Need for 1099s

For each contractor receiving 1099-NEC:

• Full legal name or business name

• Taxpayer Identification Number (TIN): SSN for sole proprietors, EIN for LLCs

• Current mailing address

• Tax classification (sole proprietor, LLC, S-corp)

• Total amount paid for services during 2025

Where data comes from: Unlike payroll, contractor payments scatter across systems—accounting software, Bill.com, wire transfers, credit cards (which generate 1099-K, not 1099-NEC from you).

Common problems:

1. Missing W-9 forms: You paid someone $8,000 but never collected their TIN. Now you're chasing them in December.

2. Incorrect TIN: Wrong SSN or EIN triggers IRS mismatch notices and backup withholding requirements.

3. Payment tracking across systems: Consolidated totals from multiple payment methods.

4. Reimbursements incorrectly included: Track reimbursements separately—they're not compensation.

Industry-specific contractor types to track:

• Law firms: Contract attorneys, expert witnesses, court reporters, process servers

• Healthcare: Locum tenens providers, billing services, transcriptionists

• Creative agencies: Freelance designers, photographers, writers, videographers

• IT services: Subcontractors, specialized developers, security consultants

• Nonprofits: Grant writers, fundraising consultants, program facilitators

Action: Export a 2025 vendor payment report from accounting software. Cross-reference against W-9s on file. Flag anyone with $600+ payments and missing W-9 data.

Form W-9: Get It Before You Pay Anyone

Form W-9 is the foundation of 1099 compliance. Contractors provide:

• Legal name and business name

• Tax classification

• Taxpayer Identification Number

• Mailing address

• Certification that information is correct

Best practice: No W-9, no payment. Make this part of contractor onboarding:

1. New contractor signs agreement

2. Request completed W-9 before first payment

3. Verify TIN format (SSN: XXX-XX-XXXX, EIN: XX-XXXXXXX)

4. Store securely

5. Proceed with payment

Without a W-9: You must impose backup withholding—withhold 24% of all payments and remit to IRS. A designer invoicing $5,000 only receives $3,800. You send $1,200 to the IRS using Form 945. This creates relationship friction and administrative burden.

Storage: Keep W-9s for at least 4 years. Store encrypted—they contain sensitive information. Don't file with IRS; they're for your records only.

Your December Documentation Checklist

Week 1 (Dec 1-7):

• Run payroll exception report (missing SSNs, name mismatches, old addresses)

• Run contractor payment report showing vendors paid $600+

• Export transactions from all payment systems

• Verify payroll tax deposits are current

Week 2 (Dec 8-14):

• Contact employees to verify addresses

• Request W-9s from any contractor missing them

• Reconcile contractor payments into consolidated totals

• Identify workers who were both employees and contractors (need both forms)

Week 3 (Dec 15-21):

• Run worker classification audit on long-term contractors

• Prepare Form W-3 (transmittal for W-2s)

• Review state-specific filing requirements

• Set up electronic filing accounts (SSA Business Services Online, IRS FIRE)

Week 4 (Dec 22-31):

• Process final 2025 payroll

• Handle year-end bonuses

• Complete payroll reconciliation

• Generate draft W-2s and 1099-NECs for review

For detailed operational guidance on executing the final payroll close, see: Year-End Payroll Wrap-Up: Ensuring Smooth W-2s and Contractor 1099s.

Meet Deadlines, Follow Filing Rules, and Handle Corrections Without Panic

Timing matters. Late filing penalties escalate quickly, and the IRS rarely grants relief for "I forgot."

Critical Deadlines You Cannot Miss

January 31, 2026: Furnish W-2s to employees and 1099-NECs to contractors (mail, hand-deliver, or electronic with consent). Workers need these to file personal tax returns.

February 2-3, 2026: File W-2s with Social Security Administration and 1099-NECs with IRS. (Exact date shifts based on weekends.)

Late Filing Penalties

Real cost: 15 employees + 8 contractors = 23 forms. Miss deadline by 60 days: $2,530 in penalties. Never file: $6,670.

State penalties stack on top.

Electronic vs Paper Filing

Electronic filing required if:

• You're filing 250+ forms of the same type

Why e-file anyway:

• Faster processing (confirmation within 24-48 hours)

• Built-in validation catches errors before submission

• No need for special red-ink forms

• Usually free through payroll/accounting software

How to e-file:

• W-2s: SSA Business Services Online or through payroll provider

• 1099-NECs: IRS FIRE System or tax software (QuickBooks, TaxAct)

For a complete timeline of all tax deadlines and preparation guidance: Key Tax Deadlines for Early 2026 (and How to Prepare).

How to Fix Mistakes After Forms Go Out

For W-2 errors: File Form W-2c (corrected statement) with Form W-3c (transmittal). Send corrected copies to employee and SSA.

For 1099 errors: File corrected 1099-NEC with "CORRECTED" box checked. Send copies to contractor and IRS.

Timing: File corrections immediately when you discover errors. The IRS doesn't penalize good-faith corrections filed promptly.

For completely forgotten forms: Submit as soon as you realize. Mark "Filed late." The IRS assesses late penalties but won't double-penalize for correcting.

State Filing Requirements

Most states require separate W-2 and 1099 filings. Some accept federal forms; others use state portals. Deadlines typically mirror federal dates (Jan 31, early Feb) but occasionally differ.

Multi-state considerations:

• Law firms with multiple office locations

• Healthcare practices with satellite clinics

• Creative agencies with remote teams nationwide

• IT services serving clients across states

For comprehensive year-end compliance beyond W-2s and 1099s: Small Business Tax Compliance Checklist for Year-End.

Build Systems Now, File Confidently Later

Year-end payroll tax filing doesn't require stress. Professional service firms that handle this smoothly share common practices:

They classify workers correctly from day one. Clear documentation of the three-factor test for every contractor relationship. No gray area workers who might be employees.

They collect W-9s before making first payments. Form W-9 collection is part of contractor onboarding. No W-9 means no payment—a rule that eliminates December chaos.

They maintain clean, consolidated records. One system of record for contractor payments. Regular reconciliation between payment systems and accounting records.

They track deadlines proactively. Calendar reminders starting in November. December checklists completed week by week.

They invest in appropriate systems. Payroll software that automates W-2 generation. Accounting systems with 1099 tracking. Professional help when complexity exceeds internal capacity.

When to Get Professional Help

Consider engaging a payroll specialist, CPA, or outsourced accounting firm if:

• You have 10+ employees or complex multi-state payroll

• You've misclassified workers previously

• You've received IRS notices about missing or incorrect forms

• You spend 10+ hours monthly on payroll and compliance

• Admin burden pulls you from serving clients

Professional help costs $200-500/month for payroll services, $800-2,000 for year-end filing. Often less than a single misclassification penalty.

The goal: Turn year-end filing from crisis into routine. When you nail classification, documentation, and deadlines, January becomes predictable instead of panic-inducing.

For last-minute strategies to optimize your tax position before year-end: Last-Minute Tax-Saving Moves to Consider Before Year-End.

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Professional service firms—whether legal, healthcare, creative, IT, or nonprofit—face unique payroll compliance challenges. Our specialized finance team handles W-2 and 1099 filing, worker classification reviews, and year-round compliance so you can focus on serving clients. Schedule a consultation to discuss your situation.