Explaining the Risks of Contractor Tax Payments

The IRS and Department of Labor take employment classification and tax compliance seriously. Paying contractors off the books doesn’t just bend the rules. It breaks them. For business owners, this approach can lead to back taxes, heavy penalties, and even legal action.

In this article, we explain what under-the-table payments mean, why they’re so risky, how legitimate contractor tax payments should be handled, and how to protect your business from compliance issues before it’s too late.

What Does “Paying Under the Table” Mean?

“Paying under the table” refers to compensating someone for work without reporting it to the IRS. These payments are typically made in cash and never recorded on official books or tax forms.

While some business owners justify it as a way to save on taxes or simplify processes, it’s still considered tax evasion, a federal offense.

Even if you believe your intentions are harmless, the IRS views unreported payments as deliberate concealment of income and payroll obligations.

Contractor vs. Employee: The IRS Classification Rules

Before discussing compliance, it’s important to understand how the IRS distinguishes independent contractors from employees. The classification determines who’s responsible for tax withholdings, reporting, and employment benefits.

The IRS uses three main factors to assess worker classification:

Behavioral Control: Does the company dictate how, when, and where the worker performs their job?
Financial Control: Does the company control how the worker is paid, provide tools, or reimburse expenses?
Relationship Type: Is there a written contract? Does the worker receive benefits like insurance or paid time off?

If you exercise significant control over a worker’s schedule, tools, and income, the IRS is more likely to classify them as an employee, not a contractor.

Paying Contractors Legally vs. Under the Table

Category	Paying Contractors Legally	Paying Under the Table
Documentation	W-9 on file; issues Form 1099-NEC at year-end	No records; no forms filed
Tax Reporting	Income reported to IRS and contractor	Income unreported; violates tax law
Payment Method	Check, direct deposit, or accounting system	Cash or untraceable payment
Liability	Compliant with IRS rules	Exposed to audits, penalties, back taxes
Transparency	Fully traceable and documented	Hidden transactions; high-risk behavior

Paying contractors legally is not only safer but also builds credibility with vendors, employees, and clients. Under-the-table payments, on the other hand, can erode trust and jeopardize your business reputation.

The Real Risks of Paying Contractors Under the Table

At first glance, paying under the table may seem harmless, especially for small projects or short-term work. But the financial and legal risks are steep.

1. IRS Penalties and Back Taxes

If caught, the IRS can demand years of back taxes, interest, and civil penalties. Businesses may also lose deduction eligibility for unreported payments, raising taxable income even higher.

2. State and Federal Violations

Beyond federal tax evasion, under-the-table payments can violate state labor laws and workers’ compensation rules. Some states even impose criminal charges for unreported wages.

3. Lost Deductions and Audit Triggers

Unrecorded expenses can’t be deducted. Plus, inconsistent cash outflows raise red flags during IRS audits, increasing the likelihood of scrutiny.

4. Legal Liability for Worker Misclassification

If a contractor you’ve paid under the table files for unemployment or reports unpaid income, the IRS can reclassify them as an employee, forcing you to cover unpaid payroll taxes, Social Security, and Medicare contributions.

5. Damage to Business Reputation

Public record penalties and IRS liens can harm your credibility with banks, investors, and clients. Once your business is associated with noncompliance, rebuilding trust takes years.

How to Pay Contractors the Right Way

Getting contractor payments right isn’t difficult—it just requires structure and documentation.

Step 1: Collect a Form W-9

Before paying any contractor, have them complete a Form W-9, which provides their taxpayer identification number (TIN).

Step 2: Report Payments With Form 1099-NEC

If you pay a contractor $600 or more during the tax year, you must issue a Form 1099-NEC to both the contractor and the IRS.

Step 3: Keep Accurate Records

Use accounting software to record payments, invoices, and project details. Good bookkeeping supports deductions and simplifies audits.

Step 4: Verify Classification Regularly

Roles evolve over time. Review each contractor’s status annually to confirm they still meet IRS contractor guidelines.

Common Questions About Contractor Tax Payments

How do contract workers pay taxes?

Independent contractors are responsible for paying their own income tax and self-employment tax (covering Social Security and Medicare). They typically make quarterly estimated tax payments to the IRS.

What if I only paid them once or twice?

Even a single payment must be reported if it exceeds $600 in a calendar year. Noncompliance can still lead to penalties.

Can I switch from paying under the table to doing it legally now?

Yes—and you should. The longer you wait, the higher the penalties may become. A CPA can help you correct past errors and establish compliant systems moving forward.

Avoid costly tax filing mistakes that lead to penalties, audits, or lost savings. Learn how to protect your business and file with confidence.

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Real-World Example: A Costly Mistake

A small construction company owner began paying subcontractors in cash to avoid “paperwork headaches.” After a former worker filed for unemployment, the IRS audited the business and determined those subcontractors were actually employees.

The result? Nearly $40,000 in back taxes and penalties, not to mention reputational damage and years of financial strain.

What felt like a shortcut turned into a long-term setback.

Why Businesses Still Take the Risk

For many small businesses, the appeal of under-the-table payments lies in convenience—no payroll taxes, no forms, no waiting. Others simply don’t understand the reporting requirements or think the IRS won’t notice.

But with digital banking, electronic recordkeeping, and IRS data-matching technology, off-the-books transactions rarely go unnoticed for long. Modern compliance systems make detection faster and more accurate than ever before.

Protecting Your Business Through Compliance

The best protection is prevention. Proactively managing contractor classification and documentation reduces the risk of future penalties. Working with a CPA also ensures you stay compliant as laws and reporting thresholds evolve.

A qualified tax professional can:

Review your contractor agreements for IRS compliance
Set up 1099 tracking and reporting systems
Advise on payroll alternatives for reclassified employees
Identify legitimate deductions related to contract labor
Help you transition from noncompliance safely and legally

Stay Compliant and Confident With Proper Contractor Tax Payments

Paying contractors under the table may feel like an easy fix, but it comes with real, lasting consequences. The IRS doesn’t just penalize intentional fraud, even accidental errors can cost thousands in back taxes and lost deductions.

The good news? Compliance doesn’t have to be complicated. With clear processes, accurate documentation, and help from trusted tax professionals, you can protect your business while maintaining full transparency.

Ready to make sure your contractor tax payments are compliant? Contact Manley Garvin LLC today to schedule a consultation with our tax advisors.

The Risks of Contractor Tax Payments