Contractor: Employee vs Subcontractor

One of the most consequential decisions for any growing contractor business is whether to bring on workers as employees (W-2) or use them as subcontractors (1099). Get it right, and you have flexibility and cost control. Get it wrong, and you’re looking at IRS penalties, unpaid payroll taxes, and potential back payments that can sink a business.

Here’s a complete breakdown of employee vs. subcontractor status for contractor businesses — what the IRS requires, what’s financially at stake, and how to make the right call.

Why This Classification Matters So Much

The IRS audits worker misclassification aggressively. If the IRS determines that you classified workers as independent contractors when they should have been employees, you’re liable for:

• Unpaid payroll taxes (employer share of Social Security and Medicare)
• Failure-to-withhold penalties
• Back payments of federal and state unemployment taxes
• Potential interest on back taxes
• Civil penalties

The IRS Section 530 Relief Program provides some protection if you followed a reasonable basis for classification — but it’s not a blank check to call all workers 1099.

In Texas, the Texas Workforce Commission (TWC) also audits worker classification for state unemployment tax purposes. Violations can result in back UI taxes and penalties.

The IRS “ABC” Test Framework

The IRS uses a multifactor “common law” test — sometimes summarized as the ABC framework — to determine worker classification:

A — Behavioral Control

Does your business control how the worker performs the work (not just the end result)?

• Employee indicators: You set the hours, you provide the tools and supplies, you dictate the work process, you require attendance at specific times
• Subcontractor indicators: The worker determines how to complete the job, uses their own tools, sets their own schedule, controls their work process

B — Financial Control

Does your business control the business aspects of the worker’s job?

• Employee indicators: The worker is paid a fixed hourly rate or salary, you reimburse expenses, you provide the equipment, they have no financial risk
• Subcontractor indicators: The worker is paid per project, they have their own significant investment in tools/equipment, they can make a profit or take a loss, they work for multiple clients

C — Relationship Type

What is the nature of the working relationship?

• Employee indicators: There’s a written employment agreement, you provide benefits, the relationship is ongoing and exclusive, the work is core to your business
• Subcontractor indicators: There’s a written subcontractor agreement, no benefits, relationship is project-specific, the worker has their own business entity and other clients

No single factor is determinative — the IRS looks at the totality of the relationship.

Real-World Examples in Contracting

Likely employee:

• You hire Joe to work on all your jobs, Monday–Friday, 7am–4pm, using your truck and your tools, and he doesn’t work for anyone else.

Likely subcontractor:

• You hire Maria’s Plumbing LLC to do all plumbing rough-in on your residential jobs. Maria has her own plumbing license, her own tools, works for other general contractors, and invoices you per project.

Gray area:

• You hire Dave informally to help on jobs a few times per month. Dave uses mostly your tools, works the hours you tell him to, but also does some odd jobs for neighbors on his own. This is a genuine gray area — document carefully.

Cost Comparison: Employee vs. Subcontractor

Hiring a W-2 employee costs more per hour than paying a 1099 subcontractor for the same hourly rate — because employees trigger payroll taxes and benefits:

Cost Component	W-2 Employee	1099 Sub
Gross wages/pay	$25/hr	$25/hr
Employer SS/Medicare (7.65%)	$1.91/hr	—
Federal/State Unemployment	~$0.60/hr	—
Workers’ comp insurance	$2–$6/hr (varies by trade)	— if sub has own
Health benefits (if offered)	$3–$8/hr equivalent	—
Total employer cost	~$35–$45/hr	$25/hr

This cost differential is real — but it doesn’t mean subcontractor is always the right choice. The risk of misclassification penalties plus the liability exposure from uninsured subs must factor in.

Protecting Yourself When Using Subcontractors

If you legitimately use subcontractors, do it correctly:

1. Written subcontractor agreement: Define the relationship explicitly — project scope, payment terms, independent contractor status, their responsibility for their own taxes and insurance
2. Collect a W-9: Required to issue a 1099-NEC at year end (for subs paid $600+)
3. Verify their insurance: Require a certificate of insurance naming you as additional insured. An uninsured sub who gets hurt on your job creates liability exposure.
4. Verify their licensing: If the sub performs licensed work (electrical, plumbing), ensure they hold the required license
5. Issue 1099s: At year-end, issue 1099-NEC forms to all subcontractors paid $600+ during the year

See our guide to contractor invoicing best practices for tracking payment records that make year-end 1099 filing straightforward.

When W-2 Makes More Sense

Despite the higher cost, employees are the right structure when:

• You need reliable workers available every day you operate
• The work is core to your business and requires your process and standards
• You want to train and develop your team in your specific methods
• You’re scaling to a crew and need management control
• Workers’ comp risk on your jobs is high (fall risk, heavy equipment)

The control you get with W-2 employees — in terms of availability, process standards, and team culture — often justifies the premium over subcontractor arrangements for established businesses.

See our guide on scaling from solo contractor to crew for more on the transition.

Frequently Asked Questions

What is the difference between a W-2 employee and a 1099 subcontractor for a contractor business?

A W-2 employee works under your direction and control, and you handle their payroll taxes, withholding, and potentially benefits. A 1099 independent contractor is a separate business you hire for specific projects — they handle their own taxes and benefits. The distinction matters significantly for IRS reporting requirements, payroll costs, workers’ compensation exposure, and potential liability.

Can I use subcontractors instead of employees to save money in Texas?

You can use legitimate subcontractors in Texas to keep costs lower, but only if the working relationship actually qualifies as independent contracting under IRS and Texas Workforce Commission standards. Using 1099 classification simply to avoid payroll taxes for workers who function as employees is illegal and carries significant financial penalties if audited.

What happens if the IRS determines I misclassified employees as subcontractors?

The IRS can assess back payroll taxes (employer share of FICA), failure-to-withhold penalties, and interest. Penalties vary based on whether the misclassification was inadvertent or intentional, and whether you had a “reasonable basis” for the classification. The total liability can be substantial — often exceeding the cost savings that motivated the misclassification. Consult a tax professional if you’re uncertain about your worker classifications.

Does Texas require workers’ compensation insurance for subcontractors?

Texas is the only state where workers’ compensation insurance is not mandatory for employers. However, just because it’s not required doesn’t mean it’s without risk. If you hire uninsured subcontractors and one is injured on your job, you may face personal liability. Requiring subs to carry their own workers’ comp and verifying the certificate of insurance protects you.

Do I need to issue a 1099 to every subcontractor I use?

You must issue a 1099-NEC to any individual or sole proprietor subcontractor you paid $600 or more during the tax year. LLCs taxed as corporations or S-corps generally do not require 1099s (though some exceptions apply). Collect W-9 forms from every sub before paying them so you have the information needed for year-end reporting. Track all sub payments in your accounting system.