I'm a software developer and currently am exclusively freelancing, but have been a W-2 employee in the past. I have two clients for whom I have worked in both capacities. As far as I know, there's no legal/financial penalty for the employee if the IRS determines they were misclassified as a contractor. My understanding is that most of the time, companies do this to avoid paying taxes and benefits, so it's often the misclassified employees themselves who blow the whistle on the practice.
From what you described, this definitely seems like they are misclassifying you and my biggest hesitation would be what their willingness to risk this implies about the rest of their business practices (i.e. they're either too incompetent or too stingy to avoid this risk).
That said, unless the health care costs are huge (unlikely since you're young), you should come out well ahead financially, partly because of the 20% QBI deduction someone already mentioned (
https://www.nolo.com/legal-encyclopedia/the-new-pass-through-tax-deduction.html ), and because if you set up an LLC, you can also set up your own 401(k) plan to which you can contribute significantly more than what you could if you were an employee (20% of your net income in addition to the standard $18,500).
In short -- I'm not a lawyer but unless they're sketchy in other ways and this is one of multiple red flags, I would do it since they likely won't get caught, and if they do, all the risk is on them.
Another option would be to say, "Hey, this sounds good but I'm worried about getting you in trouble with the IRS, let's make sure this is a bona fide consulting situation" and decline the vacation time, raise your rate accordingly, and write up a contract that gives you some more flexibility on working hours etc. Could be a win-win and show them you're a serious professional and looking out for them.
