1099 or W-2 for US network marketing, IRS tests explained

What to take away

• Direct selling distributors are usually treated as independent contractors and paid on Form 1099-NEC, but that label holds only if the working relationship passes the IRS common-law test.
• The IRS weighs behavioral control, financial control, and the parties' relationship; Publication 15-A is the agency's own summary of those rules.
• Roughly half the states use some version of the ABC test, which is stricter than the federal standard and puts the burden of proof on the hiring company.
• Distributors pay self-employment tax once net profit reaches the filing threshold, reported on Schedule C.
• California and Illinois both penalize misclassification, but through different mechanisms and with different exposure.
• Audits rarely begin with a classification theory. They start with a filed form, a benefits claim, or a worker complaint.

Why classification decides whether a distributor gets a 1099 or a W-2

A W-2 means the company withholds income tax, pays half the Social Security and Medicare tax, covers unemployment insurance, and answers to wage-hour law. A 1099-NEC means the distributor handles all of that personally and files a Schedule C.

The difference in cash is not small. On a $30,000 commission year, the employer half of Social Security and Medicare alone runs into the thousands, before unemployment insurance and workers' compensation.

Classification also sets who bears risk. An employee who is shorted on pay has a state labor agency behind them. A contractor generally has a contract and a civil claim.

For a distributor, the practical question is whether the arrangement survives scrutiny. The label on the contract matters less than how the work actually runs day to day. For a side-by-side of the two outcomes, see our comparison of 1099 vs W-2 treatment.

What tips an arrangement toward employee status

A company that sets call hours, scripts the pitch, requires attendance at weekly meetings, assigns territories, and prohibits other work is describing an employee. So is a company that reimburses expenses, supplies leads, and reviews performance the way a sales manager would.

What supports contractor status

A distributor who buys product at wholesale, sets their own hours, recruits their own downline, sells to customers they found, and can work other jobs looks like a business. Profit and loss potential, not just commission, is the point.

IRS common-law factors and the 20-factor test applied to distributors

The IRS publishes its current thinking in Independent contractor (self-employed) or employee?. The agency groups the evidence into behavioral control, financial control, and the type of relationship.

The older 20-factor test grew out of Revenue Ruling 87-41 and is still cited in training materials, though the IRS now presents the same ideas as categories rather than a checklist. The factors did not disappear. They were reorganized.

No single factor decides a case. The IRS looks at the whole picture and weighs the facts that matter most to the industry in question. A broad non-compete clauses restriction is one of the facts that cuts toward employee status, because it limits the distributor's freedom to work elsewhere.

Behavior and control factors

• Instructions: does the company dictate how, when, and where the selling happens?
• Training: is there ongoing required training, or an initial orientation only?
• Set hours: are there mandatory call times, shifts, or event attendance?
• Work location: must the distributor work from a company site or assigned territory?
• Order of work: does the company sequence the distributor's tasks?
• Hiring assistants: can the distributor bring on help without approval?
• Payment method: hourly or salary looks like employment; commission on sales looks like contracting.

Financial and relationship factors

• Expenses: who supplies tools, samples, and leads?
• Investment: does the distributor have real money at risk in inventory or equipment?
• Profit or loss: can the distributor lose money on the arrangement?
• Services to others: is the distributor free to sell for other companies?
• Written contract: what did the parties say they intended?
• Benefits: are there paid leave, insurance, or retirement contributions?
• Permanency and integration: is the relationship indefinite, and is the selling central to the company's regular business?

A worked example

A Utah supplement company pays 25 percent commission, requires attendance at a Monday night Zoom, assigns each distributor a 40-mile territory, and forbids selling competing brands. The distributor buys inventory at wholesale and can lose money. The contract calls them a contractor.

Three factors push toward employee: required meetings, assigned territory, and the ban on competing work. The inventory investment and commission-only pay push the other way. This is the kind of fact pattern that gets argued, not resolved by the contract's title.

The ABC test and how states diverge from the federal standard

The ABC test comes from unemployment insurance law and asks three questions. A worker is an employee unless the hiring entity proves all three.

1. The worker is free from control and direction in performing the work, both under the contract and in fact.
2. The work is outside the usual course of the hiring entity's business.
3. The worker is customarily engaged in an independent trade, occupation, or business of the same nature.

Part B is the killer for direct selling. A company whose usual course of business is selling through distributors will struggle to show that a distributor's selling is outside that course.

The federal standard is different. The IRS weighs factors and reaches a judgment. The ABC test is a burden-shifting rule: fail any prong and the worker is an employee.

Which states use which test

California, Massachusetts, New Jersey, Connecticut, Illinois in some contexts, and a growing list of others apply ABC or a close variant for at least some statutes. Texas, Florida, and most of the South rely on common-law or right-to-control tests.

A distributor can be a contractor for federal tax purposes and an employee for state unemployment purposes at the same time. The tests serve different statutes.

That split is why national companies sometimes run two compliance tracks. Federal forms and state unemployment registrations do not have to match.

Where the states are heading

Several states have narrowed their tests through legislation or court decisions since 2019. Others have passed laws reaffirming the common-law standard. The direction depends on the statehouse, not on the IRS.

Companies that operate in multiple states should map their distributor agreements against the strictest state they touch, not the loosest. A California rule can end up governing a national program.

Publication 15-A and Publication 15 on withholding and employment tax

Publication 15-A (2026), Employer's Supplemental Tax Guide | Internal Revenue Service is the IRS document that covers worker classification, fringe benefits, and other supplemental employment tax topics. It restates the three-category test and explains what happens when a worker is reclassified.

Publication 15, the Circular E, covers withholding, FICA, and deposit rules for employees. If a distributor is an employee, the company follows Publication 15. If not, Publication 15 does not apply to those payments.

Publication 15-A also addresses backup withholding. A company that fails to collect a correct taxpayer identification number from a 1099-NEC recipient may have to withhold at the backup rate.

Form 1099-NEC basics

The About Form 1099-NEC, Nonemployee Compensation | Internal Revenue Service page explains the form used to report payments of $600 or more to nonemployees in the course of a trade or business.

Payments to a corporation are generally exempt, with exceptions for attorneys and certain other services. Commissions, fees, and prizes paid to a distributor are reportable.

The form is due to the recipient and the IRS by the end of January following the payment year. Missing that deadline triggers penalties that scale with lateness.

What companies get wrong

Two errors repeat. First, treating a distributor as a contractor for tax purposes while treating them as an employee for control purposes. Second, failing to issue a 1099-NEC because the distributor never asked.

The obligation runs from the payer, not the recipient. A distributor who does not want a 1099 does not relieve the company of the duty to file one.

Self-employment tax thresholds and Schedule C reporting for distributors

A distributor with net profit of $400 or more from self-employment must file a return and pay self-employment tax. That threshold has been $400 for decades and applies to net earnings, not gross commissions.

Self-employment tax covers Social Security and Medicare at the same combined rate employees and employers pay together. Half of it is deductible against income.

Gross commissions go on Schedule C, not on the 1099-NEC amount alone. The distributor subtracts business expenses: product cost, samples, shipping, event fees, and mileage.

Publication 334 (2025), Tax Guide for Small Business | Internal Revenue Service walks through Schedule C, self-employment tax, and estimated payments for sole proprietors.

The deduction that matters most

Product purchased for personal use is not a business expense. Product purchased for resale or for samples is. That distinction trips up distributors who buy inventory to hit a monthly purchase requirements threshold and then consume it at home.

Inventory must be tracked. A distributor who buys $12,000 of product and sells $9,000 has $3,000 in ending inventory, not a $12,000 deduction.

Estimated taxes

Self-employment tax and income tax are not withheld from commissions. Distributors generally must pay quarterly estimated taxes or face an underpayment penalty.

A distributor who also holds a W-2 job can have withholding increased on that job instead of making quarterly payments. Either way, the money is owed.

Recordkeeping checklist

• Keep every 1099-NEC received and reconcile it to gross commissions
• Track cost of goods sold and ending inventory separately
• Log business mileage with dates and destinations
• Save receipts for samples, training events, and convention travel
• Record home office square footage if a space is used regularly and exclusively
• Set aside a percentage of each commission check for taxes
• File quarterly estimates or adjust W-2 withholding to cover the liability

California misclassification penalties under AB 5 and related rules

California codified the ABC test in AB 5 in 2019 and has been litigating its edges ever since. Dynamex, the 2018 decision behind the statute, already applied ABC to wage orders.

Penalties under Labor Code 226.8 run from $5,000 to $15,000 per violation for willful misclassification. That is per worker, and the state can stack claims.

A separate civil penalty of $10,000 per violation applies where the state finds a pattern or practice of willful misclassification. The Labor Commissioner and the Attorney General can both pursue it.

What else California adds

Reclassified workers can recover unpaid wages, overtime, and expense reimbursements. Waiting time penalties accrue for each day wages were late, up to a cap.

AB 5 also created the concept of the wage order's reach. A distributor classified as an employee under a wage order may be owed meal and rest breaks, which are hard to provide to a remote seller.

California's EDD audits unemployment insurance accounts and can reclassify distributors years back. The lookback period for unpaid contributions is typically three years, longer in some cases.

The practical exposure

For a company with 500 California distributors, a willful misclassification finding at the statutory minimum is a seven-figure problem before wage claims and attorney fees. That is why several direct selling companies restructured California operations rather than litigate.

A distributor agreement alone does not cure this. California looks at the actual relationship, and the burden is on the company to prove all three ABC prongs.

Illinois misclassification penalties and state filing exposure

Illinois does not have a single AB 5 style statute. It applies the ABC test to unemployment insurance and workers' compensation, and a right-to-control test to most wage claims.

The Employee Classification Act, which covers construction, has its own penalties and does not reach direct selling. The Workplace Transparency Act added reporting requirements for employers.

Under the Illinois Unemployment Insurance Act, a finding of misclassification can trigger unpaid contributions, penalties, and interest. The Department of Employment Security pursues these through audits.

Penalties and interest

Illinois assesses contributions owed plus a penalty that grows with the length of the delinquency, and interest accrues on the unpaid balance. Willful violations can draw additional fines.

The state can also pursue the officers of a company personally in some circumstances. That is a bigger risk for small direct selling companies than for large ones.

The Illinois twist for distributors

Illinois courts have looked at whether a distributor is genuinely in business for themselves. A distributor with a single company, no other clients, and no independent marketing presence looks less like a business.

Illinois also requires employers to provide written notice of classification status to workers under some statutes. Missing that notice is a separate violation.

For companies operating in both California and Illinois, the compliance work overlaps but does not match. A California fix does not automatically satisfy Illinois.

DOL misclassification guidance and how audits actually start

The Misclassification of Employees as Independent Contractors Under the Fair Labor Standards Act | U.S. Department of Labor page sets out the agency's position. The DOL uses an economic realities test for minimum wage and overtime, which asks whether a worker is economically dependent on the employer.

Economic dependence is a broader question than control. A distributor who earns most of their income from one company may be dependent even if they set their own hours.

The DOL and the IRS do not share a single test, and a worker can be a contractor for one and an employee for the other. That is not a contradiction in the law. It is how the statutes are written.

How an audit actually begins

Most classification audits do not start with a theory. They start with a document.

1. A worker files for unemployment benefits after the relationship ends, and the state agency asks the company to prove the worker was a contractor.
2. A distributor files a wage claim with a state labor agency, which opens a file and requests records.
3. The IRS receives a mismatch notice on a 1099-NEC with a wrong taxpayer identification number.
4. A state revenue department cross-checks 1099-NEC filings against business registrations and finds distributors with no registration.
5. An injured distributor files a workers' compensation claim, and the carrier disputes coverage.
6. A competitor or a former insider files a complaint with a state attorney general's office.

Each path leads to the same question: was this person an employee? Once the question is asked, the company has to answer with facts, not with the contract.

What to have ready

A company that can produce signed agreements, evidence of the distributor's business registration, records of the distributor's other customers, and documentation of real profit and loss potential is in a better position. A company that can only produce a contract is not.

Where the industry sits

The Direct Selling Association has argued for years that distributors are independent businesses, and many are. The ones who fail the tests are usually the ones whose companies treated them like employees while calling them contractors.

That gap is the whole risk. It shows up in call scripts, mandatory meetings, and territory assignments, not in the 1099-NEC itself.

Common questions

Does a distributor always get a 1099-NEC? No. A distributor who is treated as an employee gets a W-2. The 1099-NEC applies only when the company has a reasonable basis to treat the distributor as a nonemployee and pays $600 or more in a year.

What is the self-employment tax threshold? Net earnings of $400 or more from self-employment trigger the filing requirement and self-employment tax. The threshold applies to profit after business expenses, not to gross commissions.

What happens if a company misclassifies in California? Labor Code 226.8 penalties run from $5,000 to $15,000 per violation for willful misclassification, with an additional $10,000 per violation for a pattern or practice, plus back wages and expense reimbursements.

Do distributors need an LLC to be contractors? No. A sole proprietor with a Schedule C can be a legitimate contractor. Forming an LLC does not fix a relationship that otherwise looks like employment.

How far back can a state audit go? Three years is typical for unemployment insurance contributions, and longer where the state finds willful failure to file or fraud. Records should be kept at least four years.

Do cooling-off laws affect classification? Not directly, but cooling-off laws shape how quickly a distributor can exit, and a fast exit with a refund is one sign the distributor bore real financial risk. Our focused business guide covers the operating side of that relationship.