Yep, its definitely illegal. I worked for a guy that gave his employees 1099's. He must have "covered" himself by saying at the interview he didn't take out taxes. I never thought anything about it, no big deal I thought. Come to find out at tax time I'm getting taxed more because of it since I have to pay his share in my SE Tax.
Not to mention he didn't have workmans comp, so when someone got hurt he was in a real tissy. I imagine he also claimed our payroll as a business expense since we were considered contractors. Once I found out what he was doing, I felt real cheap and cheated, and my desire to work for him crashed and burned. I am now starting my own business and will run it the right way. All of you bosses out there, treat your employees well and they will keep working for you and do a good job. This guy always wondered why his good help quit.