Paying Contractors in Cash: IRS Rules, 1099 Requirements, and Audit Risk

Written by Sam Brotman, J.D., LL.M. (Taxation), MBA — Managing Attorney, Brotman Law  ·  Updated May 2026

The Short Version

Paying contractors in cash is legal. The IRS doesn't regulate how you pay — it regulates whether you report it.

The obligation is Form 1099-NEC. If you paid an independent contractor $2,000 or more for services during calendar year 2026, you're required to file that form with the IRS and deliver a copy to the contractor by January 31, 2027. Fail to do it and you're looking at civil penalties. Do it as part of a deliberate scheme to hide payroll and you're in criminal territory.

The rest of this guide covers the mechanics: exactly when the 1099 requirement applies, what the IRS looks for when auditing cash-intensive businesses, how California's EDD fits in, and at what point a reporting problem crosses into criminal exposure.

When Does Paying a Contractor in Cash Require a 1099?

The $2,000 threshold applies to payments made in 2026 and forward, indexed for inflation in $100 increments starting in 2027. For payments made in 2025 or earlier, the old $600 threshold governs — meaning if you're filing the 2025 return right now, $600 is still your line.

A few clarifications that trip people up:

• The threshold is per contractor, per year. If you paid three different people $800 each in cash in 2026, none of them clears the $2,000 threshold and no 1099-NEC is required for any of them. Pay one person $2,200 across multiple cash payments and a 1099 is required.
• The rule covers services, not goods. If you paid a contractor $3,000 in cash for materials and parts, that payment may not require a 1099-NEC. If they provided labor or services — even incidentally — the calculation changes.
• Payments made to corporations are generally excluded. If your contractor is incorporated (an S-corp or C-corp), 1099-NEC is not required. The exception is payments to attorneys, which require a 1099 regardless of entity type.
• The payment method is irrelevant. Cash, check, Zelle, Venmo for business — the threshold and form requirements are the same. The misconception that cash payments somehow fall outside the 1099 system is exactly what creates audit exposure.

The form to use is Form 1099-NEC (Non-Employee Compensation). It replaced Box 7 of the old Form 1099-MISC for most contractor payments beginning in tax year 2020. If you're still filing 1099-MISC for contractor labor, you're using the wrong form.

What Happens If You Don't File a Required 1099?

The penalty structure under IRC §§ 6721 and 6722 works as follows:

There's a separate issue beyond the 1099 itself. If you claim a deduction for contractor payments but didn't file the required 1099, the IRS can disallow the deduction under IRC § 162(a) — and they do. That is a separate problem from the penalty, and it affects your bottom-line tax liability.

Finally: a contractor reporting their own income doesn't protect you. The 1099 is your obligation. If the IRS audits your contractor and finds unreported income, they often work backwards to you.

How the IRS Finds Unreported Cash Contractor Payments

The most common discovery route is the 1099 matching program. The IRS electronically cross-references the 1099s you filed against the contractor's income tax return. If the contractor reported less than the amount on your 1099, they get a notice. If they reported income but you never filed a 1099, you get flagged. Gaps in either direction trigger automated review.

A second route is the expense deduction analysis. When you audit-proof your tax return, you generally deduct contractor payments as a business expense. The IRS can see that your deducted labor costs significantly exceed the 1099s you filed. That mismatch is a standard audit selection trigger for Schedule C filers and small businesses.

Cash-specific triggers include:

• Form 8300 — required when you receive more than $10,000 in cash in a single transaction or in related transactions. If you're a cash-intensive business and someone pays you $12,000 in cash, that filing hits the IRS database and can draw a closer look at your overall cash handling.
• Currency Transaction Reports (CTRs) — banks file these automatically for cash transactions over $10,000. A pattern of cash withdrawals at the $10,000 threshold can trigger a Bank Secrecy Act review, especially if the IRS suspects structuring.
• Contractor returns and audits — if a contractor you paid is audited and their records show cash payments from your business that don't appear on your return, the IRS follows the trail.

The practical takeaway: there is no reliable way to pay cash contractors "under the radar." The mechanisms for finding these payments are systematic, not investigative.

California-Specific Exposure: EDD and Worker Classification

The California Employment Development Department audits businesses for unreported payroll and worker misclassification. The EDD doesn't need an IRS referral to open a case. A competitor complaint, a worker filing for unemployment, or a random audit selection can start the process.

Under California's AB 5 framework, the default presumption is that any worker is an employee — not a contractor. To classify someone as an independent contractor in California, you must satisfy the ABC test:

1. The worker is free from control and direction in performing the work
2. The work is outside the usual course of your business
3. The worker is customarily engaged in an independently established trade, occupation, or business

All three conditions must be met. Many of the workers people pay in cash — day laborers, construction subs, cleaners, drivers — fail the ABC test, particularly prong B. If the EDD reclassifies your cash contractors as employees, the consequences include back payroll taxes, unemployment insurance contributions, SDI contributions, and penalties that can run to 25% of the tax due, plus interest.

The IRS and EDD share information. An IRS audit that surfaces misclassified workers often results in a California referral. The two investigations are separate, but they compound.

When Paying Cash Becomes a Criminal Problem

The criminal statutes in play are:

• IRC § 7201 (Tax Evasion) — willful attempt to evade or defeat any tax. Felony, up to 5 years in prison, $250,000 fine.
• IRC § 7202 (Failure to Collect or Pay Over Tax) — willful failure to collect, account for, or pay over employment taxes. Felony, up to 5 years.
• IRC § 7203 (Willful Failure to File) — misdemeanor version, up to 1 year, for failures that don't rise to evasion.
• 31 U.S.C. § 5324 (Structuring) — breaking up transactions to avoid the $10,000 CTR requirement. Felony, up to 5 years, forfeiture of the funds.

The IRS Criminal Investigation (CI) division typically looks for a pattern before referring a case for prosecution: multiple years of unreported wages, deliberate cash-only payments to off-book workers, payroll records that don't match bank deposits, or fraudulent deductions. A single year of missed 1099s almost never ends up in front of a grand jury.

What does end up in front of a grand jury: businesses that paid workers entirely in cash for years, kept no records, and deducted the payments as generic "supplies" or "miscellaneous expenses." The IRS views that fact pattern as deliberate concealment, not negligence.

If CI is already involved — meaning you've been contacted by a special agent rather than a revenue agent — the situation is qualitatively different from a civil audit. Criminal tax cases require a different kind of defense, and the decision about what to say, what records to produce, and how to engage with investigators should go through counsel before anything else happens.

What to Do If the IRS Is Asking About Your Contractor Payments

The IRS contacts taxpayers about contractor payments in three distinct ways, and the appropriate response differs by type:

1. CP2100 or CP2100A Notice — the IRS found a TIN mismatch between your 1099 and the contractor's Social Security number. This is administrative and usually resolved by sending corrected forms or beginning backup withholding.
2. Examination (Audit) Notice — a revenue agent is examining your returns and has requested information about contractor payments. This is a civil proceeding. You have appeal rights, and the IRS is bound by its examination procedures. The key question is whether there's a worker classification issue underneath the documentation problem.
3. Criminal Investigation Contact — a CI special agent contacts you or your attorney. This is a different proceeding entirely. You have Fifth Amendment rights. The agent is not auditing you — they are building a case. Your first call is to a tax attorney, not the agent.

For situations in categories 2 and 3, the most useful thing you can do before speaking with the IRS is to gather and organize the records you actually have: contracts, invoices, bank statements, and any other documentation that supports how the payments were structured. What you don't want to do is speak to an agent first and document second — the order matters.

If you're in a position where you've been paying contractors in cash for years without proper 1099s, a voluntary disclosure is worth discussing before the IRS finds the issue on their own. The IRS's approach to taxpayers who come forward proactively is meaningfully different from how they treat those they discover through audit. We can evaluate whether a disclosure makes sense for your situation on a free call.