I usually get asked these types of questions where an employee of the "contractor" has been injured and the owner is concerned they might be liable. Under Labor Code section 2750.5, the general rule is that a property owner CAN be liable to an unlicensed contractor and his/her employees since they are assumed by presumption to be the employees of the property owner in such a circumstances. However, there are exceptions. For instance, in a 2008 case, the court held that becuase the contractor misrepresented to the owner that he was licensed when he was not, the owner could not be liable for the unlicensed contractor's injuries and the unlicensed contractor did not have the benefit of the Labor Code section 2750.5 presumption. Instead, the burden was now on the contractor to prove that he was an employee by means other than the the fact he was unlicensed. I believe the same arguments would apply as to the issue of taxes and whether or not you have a duty to pay the contractor's employees. It will turn on a number of facts, the primary one of which will be whether the contractor made any affirmative representations he was licensed for the type of work on your project, whether you should have had any suspicions about the licensing status, what steps you took to confirm whether or not the contractor was properly licensed, etc.
I'd issue a 1099 misc just to him, rather than a w-2. He's probably using a schedule C and deducting his self-employment expenses, so let him do his own calculations.
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The two prior answers are great. Treating the unlicensed contractor's employees at Independant Contractors is the best strategy based on this limited information provided. Now, for the unlicensed contractor you may not be liable to reimburse them anything (even for the work completed) per B&P 7031. Make sure to obtain fully executed lien releases forms from each of the employees. Get full identification before offering payment. Final Waiver & Release forms are recommended. Issuing a W2 witholdings creates an inference of employment. That is not recommended before consulting an attorney with everything
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