My business has been issuing 1099s to workers who I just learned are employees. How should I fix this mistake?

Once you realize that you have misclassified workers you thought were independent contractors, you should take the following actions to correct your mistake - assuming you are not under audit:

  • Immediately stop what you've been doing wrong and put the workers on the payroll.

  • Best practice. Go back to the beginning of the year and treat every payment to the workers as payroll. This will require filing federal and state employment tax returns some of which will be delinquent; consequently, there will be late filing and late payment penalties and interest.

  • Consider correcting the misclassifications in prior years. In addition to the consequences described above, you will need to issue corrected W-2s using Form W-2C. Note: Your employees may need to file amended income tax returns.

 

Voluntary Classification Settlement Program (VCSP)

 
The VCSP provides an opportunity for taxpayers to voluntarily reclassify workers as employees for federal employment tax purposes. It allows eligible taxpayers to obtain relief similar to that available through the Classification Settlement Program for taxpayers under examination.

The VCSP is an optional program that provides taxpayers not under an employment tax examination with an opportunity to voluntarily reclassify their workers as employees for future tax periods with limited federal employment tax liability for past non-employee treatment. To participate in the program, the taxpayer must meet certain eligibility requirements, apply to participate in the VCSP, and enter into a closing agreement with the IRS. This IRS article has the details.

Also read Employees vs. independent contractors