Glossary
US Payroll Compliance (W-2 vs 1099)
US payroll compliance turns on one question more than any other: is this person an employee or an independent contractor? A W-2 employee carries withholding, employer taxes and benefits obligations. A 1099 contractor carries almost none of that. Getting the classification wrong is the most expensive payroll mistake available in the US, and it compounds silently. At Treewalk we run US payroll alongside Canadian, and we test classification on every diligence engagement involving US staff.
The two categories
W-2 employees. The employer withholds federal and state income tax, Social Security and Medicare, pays the employer share of FICA, handles federal and state unemployment insurance, and files quarterly and annual returns. The employee receives a W-2.
1099 contractors. The business pays the invoice. The contractor handles their own tax, including self-employment tax. The business issues a 1099 where thresholds are met and withholds nothing.
The cost difference is substantial, which is exactly why the classification gets stretched.
Classification is decided by conduct, not paperwork
A signed contractor agreement does not settle the question. The tests look at behavioural control, financial control and the nature of the relationship: who directs how the work is done, who supplies the tools, whether the worker can profit or lose, whether the relationship is open-ended, and whether the work is core to the business.
Where the reality looks like employment, it is employment regardless of what either party signed or intended. States apply their own tests too, several of them stricter than the federal one, so a worker can be a contractor federally and an employee under state law.
The exposure when it goes wrong is unwithheld income tax, unpaid employer FICA, unemployment insurance, penalties and interest, running back across every year affected. It does not surface on the balance sheet, which is precisely what makes it dangerous.
Why this changes deals, not just tax bills
Misclassification is one of the few diligence findings that reshapes a transaction rather than just adjusting the price.
We have worked on a deal where the W-2 and 1099 population was misclassified, and the question it forced was not what discount to apply but whether the buyer wanted to assume the unrecorded liability at all. In a share purchase they inherit it. That is a live argument for structuring as an asset purchase instead, and it is the kind of finding where our input on the financial substance feeds directly into a structuring conversation with counsel.
A related pattern appears in unionised sectors. Where a business cannot avoid a union agreement directly, routing work through contractors achieves something similar in practice. That carries both classification exposure and labour exposure, and it tends to surface only when someone reads the worker list against what those people actually do.
The distinction also changes what counts as an add-back
This is a subtler point and it comes up in earnings normalization.
Contractors and employees are not equally adjustable. Contractor spend can genuinely be scaled down after close, because a buyer can identify which engagements to end. W-2 headcount is largely static: those people are staying, and their cost is staying with them.
So when a seller proposes an add-back covering a mixed pool of workers, we do not treat it uniformly. We will often allow a meaningful portion of the contractor element, on the basis that it is genuinely discretionary, while allowing nothing against the W-2 element. A claim that employees will spend a smaller share of their time on something after close does not reduce the payroll cost, because you cannot pay a salaried employee less for reallocating their attention.
What we check
| Check | Why |
|---|---|
| Worker list against actual duties | Classification is conduct-based, not contractual |
| State-by-state registration and filings | State obligations diverge from federal |
| Quarterly federal filings against remittances | Confirms nothing was missed |
| 1099 issuance against payments made | Unissued 1099s are their own exposure |
| Contractor concentration and duration | A long-term full-time contractor is the classic risk profile |
| Benefits eligibility thresholds | Misclassification can carry benefits exposure too |
Cross-border businesses run two calendars
A business employing on both sides of the border is running two entirely separate compliance systems with different deadlines, forms and thresholds. Nothing about handling one correctly helps with the other. Canadian payroll compliance covers that side, including source deductions, T4s and Records of Employment.
Frequently asked questions
Can we just have the worker sign a contractor agreement?
No. The agreement is evidence, not determination. Authorities look at how the relationship actually operates. A contractor who works set hours, uses your equipment, takes direction on method and has no other clients will be treated as an employee whatever the paperwork says.
What if a contractor asks to stay a contractor?
Their preference does not change the analysis, and it does not protect you. The liability for getting it wrong falls on the business, not the worker.
How far back does exposure go?
Potentially across every year the misclassification existed, with penalties and interest accumulating. There is no natural point at which it resolves itself, which is why it compounds quietly until diligence or an audit surfaces it.
Does this affect deal structure?
It can decide it. Where the exposure is material, a buyer may prefer an asset purchase to avoid assuming the liability, or require an escrow holdback against it. This is one of the clearest cases where a diligence finding changes the shape of the transaction.
Can you run US payroll if we are Canadian-based?
Yes. We process payroll for both Canadian and US employees, including the federal and state filings on the US side, which matters for businesses with staff across the border.
Where to next
If you use contractors in the US in roles that look anything like employment, that exposure is worth quantifying now rather than discovering it in someone else’s diligence. Our private company team handles US and Canadian payroll and the compliance calendars behind both. If a transaction is ahead, buy-side due diligence covers how classification gets tested. To talk it through, email Avnit Sekhon at avnit.sekhon@treewalk.com.
