1099 vs W-2: The Classification Mistake That Cost One Non-Profit $127,000

The letter from the IRS was 47 pages long.

A community arts non-profit in Denver had been treating their teaching artists as independent contractors for years. They'd been filing 1099s, the artists had been paying self-employment tax, and everyone seemed satisfied with the arrangement.

Until the audit.

The IRS determined that these "contractors" were actually employees. They worked regular schedules set by the organization. They used organization-provided supplies. They couldn't work for competing programs. By every reasonable measure, they were employees—just misclassified ones.

The bill: $127,000 in back taxes, penalties, and interest.

The organization had to dip into their endowment to pay it. Two board members resigned. The executive director still has nightmares about that letter.

Worker misclassification is one of the most expensive mistakes a non-profit can make. And it's one of the most common.

Why Classification Matters

When you classify someone as a W-2 employee, you're responsible for:

• Withholding federal and state income taxes
• Paying employer's share of FICA (7.65%)
• Paying federal and state unemployment taxes
• Providing workers' compensation coverage
• Potentially providing benefits (health insurance, retirement)

When you classify someone as a 1099 contractor, they handle their own:

• Self-employment taxes (15.3%)
• Quarterly estimated payments
• Health insurance and retirement
• Workers' compensation (usually)

The temptation is obvious: Contractors are cheaper. No payroll taxes. No benefits. No workers' comp. No unemployment claims.

But the IRS knows this. And they're actively looking for misclassification.

The IRS "ABC Test" for Worker Classification

While the IRS officially uses a 20-factor test, many states have adopted the simpler "ABC test." A worker is presumed to be an employee unless all three conditions are met:

A - Absence of Control The worker must be free from control and direction in performing the service, both under contract and in fact.

Questions to ask:

• Do you set their schedule?
• Do you supervise their work?
• Do you provide training?
• Can they work for competitors?

B - Business Necessity The service must be outside the usual course of your organization's business.

Questions to ask:

• Is this work central to your mission?
• Would donors expect you to have employees doing this?
• Is this an ongoing need or a one-time project?

C - Customarily Engaged The worker must be customarily engaged in an independently established trade, occupation, or business.

Questions to ask:

• Do they have their own business entity?
• Do they have other clients?
• Do they market their services publicly?
• Do they provide their own equipment?

If you can't answer "yes" to all three, the worker is probably an employee.

The Non-Profit Danger Zones

Certain roles are frequently misclassified in non-profit organizations:

Teaching Artists & Instructors

That yoga teacher who leads your Wednesday class for 52 weeks a year? The music instructor who's been teaching at your after-school program for three years? These are almost certainly employees—no matter what your contract says.

Program Coordinators

If someone is managing a program for you—even part-time—and they report to your staff, follow your policies, and use your systems, they're an employee.

Grant-Funded Positions

"But the grant only funds a contractor, not an employee!" This is one of the most common justifications—and it doesn't matter. Grant requirements don't override labor law. If the role functions as employment, it's employment. Budget accordingly.

Bookkeepers and Accountants

This one's tricky. A bookkeeper who works on-site, uses your software, and reports to your ED? Probably an employee. A CPA firm that serves multiple clients and sets their own schedule? That's a legitimate contractor relationship.

Consultants

The word "consultant" on a contract doesn't make someone a contractor. The nature of the work does. A consultant who works project-to-project with defined deliverables can be a contractor. Someone labeled "consultant" who works 30 hours a week indefinitely is an employee.

Real-World Scenarios

Let me share how classification should work in practice:

Scenario 1: The Grant Writer Your organization hires a grant writer who:

• Works from her home office
• Serves five other non-profit clients
• Sets her own hours
• Provides her own computer and software
• Bills by the project

Classification: Independent Contractor (1099) This is a legitimate contractor relationship. She runs an independent business and treats your organization as one of many clients.

Scenario 2: The Development Associate Your organization hires a "consultant" who:

• Works 25 hours weekly on a set schedule
• Uses your office and computer
• Reports to your Development Director
• Attends staff meetings
• Has been with you for two years

Classification: Employee (W-2) The label "consultant" doesn't match the reality. This person functions as a part-time employee and must be classified as such.

Scenario 3: The Graphic Designer Your organization contracts with a graphic designer who:

• Has an LLC and their own client list
• Creates specific deliverables (annual report, event materials)
• Uses their own equipment and software
• Works when and where they choose
• Has a defined end date for each project

Classification: Independent Contractor (1099) This is legitimate. They're providing a defined service as an independent business.

The Consequences of Getting It Wrong

When the IRS determines you've misclassified workers, the penalties escalate quickly:

Baseline penalties (without willful violation):

• 1.5% of worker wages for income tax not withheld
• 20% of the employee's share of FICA not withheld
• Employer's full share of FICA (7.65%)
• State taxes and penalties (vary by state)
• Potential workers' comp back-premiums

If 1099s weren't filed: Penalties increase to 3% of wages for income tax and 40% of FICA.

If misclassification was willful: The gloves come off. 100% of taxes that should have been withheld, plus fraud penalties, plus potential criminal prosecution.

Beyond taxes:

• Back-pay for overtime and benefits the worker should have received
• Workers' comp claims if someone was injured
• Unemployment claims (suddenly your "contractor" can file when you end the relationship)
• State labor board investigations

What To Do If You've Been Misclassifying

First: don't panic. The IRS has a program called the Voluntary Classification Settlement Program (VCSP) that allows organizations to reclassify workers with significantly reduced penalties.

Steps to take:

1. Stop the bleeding. Don't hire any new workers as contractors if they should be employees.

2. Assess your current workforce. Review every 1099 relationship against the ABC test.

3. Consult a professional. This is not a DIY situation. Get a CPA or employment attorney involved.

4. Consider voluntary disclosure. Depending on your situation, coming forward may be better than waiting for an audit.

5. Fix your systems. Implement a formal classification process for all new hires going forward.

January Is Coming: Your 1099 Filing Checklist

If you do have legitimate contractors, January brings filing deadlines:

By January 31, 2026:

• Issue 1099-NEC forms to all contractors paid $600+ during 2025
• File Copy A of all 1099s with the IRS

Before you file, verify:

• You have current W-9s for all contractors
• Taxpayer identification numbers are correct (the IRS matches them)
• Contractor addresses are current
• Payment totals are accurate

Don't forget:

• Attorney fees over $600 require a 1099 (even if paid to a law firm)
• Rent payments over $600 require a 1099-MISC
• Prizes and awards over $600 require a 1099

Building Classification Confidence

The Denver arts organization eventually recovered. They reclassified their teaching artists, absorbed the tax costs, and implemented proper systems. It was painful, but they survived.

"The irony," their new executive director says, "is that proper classification only costs about 10% more than what we were paying. We spent years taking on massive risk to save a few thousand dollars."

Worker classification isn't something you can afford to guess about. The stakes are too high, and the rules are too specific.

Need help reviewing your worker classifications or preparing for 1099 season? Our team helps non-profits navigate employment tax compliance and implement proper systems. Schedule a consultation to discuss your situation.

This article provides general information about worker classification rules. Federal, state, and local requirements vary, and specific situations require professional analysis. Consult with a qualified CPA or employment attorney for advice tailored to your organization.