Employee or contractor? Getting worker classification right

Why it matters

Employees require payroll. You withhold income tax, withhold and match Social Security and Medicare, pay federal and state unemployment taxes, and usually carry workers’ compensation. Contractors handle their own taxes, and you generally just issue a Form 1099-NEC if you pay them $2,000 or more in 2026.

That gap is why classification gets scrutinized. Treat an employee as a contractor and you can owe back employment taxes, penalties and interest, plus state unemployment contributions, wage-and-hour claims for overtime, and benefit plan issues. A signed contractor agreement doesn’t settle the question. The facts of the relationship do.

The IRS common-law test

For federal employment taxes, the IRS asks whether the business has the right to direct and control how the work is done, not just the result. It groups the evidence into three categories, and no single factor decides the outcome.

• Behavioral control: do you control, or have the right to control, what the worker does and how, through detailed instructions, training, set hours, required methods or regular evaluations?
• Financial control: does the worker run a real business? Look at unreimbursed expenses, investment in their own tools, opportunity for profit or loss, offering services to the public, and whether they’re paid a flat fee or a guaranteed hourly wage.
• Type of relationship: is there a written contract, are benefits like insurance or paid leave provided, is the work expected to continue indefinitely, and is it a key part of your regular business?

Two roles, two answers

Consider a dental practice. It hires a front-desk coordinator who works 9 to 5 on the practice’s schedule, uses its computers and software, follows its procedures, and has no other clients. Calling her a contractor doesn’t change much. Nearly every factor points to employee.

The same practice hires a marketing firm to redesign its website for a fixed fee. The firm sets its own hours, uses its own equipment and staff, invoices by milestone, and serves dozens of other clients. That relationship looks like a genuine contractor under the IRS test and most state tests.

Most real cases sit between those two. A part-time bookkeeper who works remotely, sets her own hours, but works only for you and is paid hourly is the kind of role that deserves a careful look.

The Labor Department and state tests

The IRS isn’t the only standard, and passing one test doesn’t mean you pass the others.

The Department of Labor applies an economic reality test for federal minimum wage and overtime. In February 2026 it proposed a rule to replace its 2024 regulation with an analysis focused on two core factors, the worker’s control over the work and the worker’s opportunity for profit or loss, and said it is no longer applying the 2024 rule in its investigations. Check the status of that rulemaking before relying on it.

States set their own rules for unemployment insurance, workers’ compensation, and wage laws. Several states, including California and Massachusetts, use an ABC test for many purposes. Under an ABC test a worker is presumed to be an employee unless the business shows the worker is free from its control, the work is outside the usual course of its business, and the worker is customarily engaged in an independently established trade or business.

That middle prong trips up many businesses. A contractor doing the same core work your company sells can fail an ABC test even if the relationship looks fine under the IRS factors.

What misclassification costs: a worked example

When the IRS reclassifies a worker and the mistake wasn’t intentional, Internal Revenue Code section 3509 often sets reduced rates for the taxes you should have withheld. You owe the full employer share of Social Security and Medicare, plus 20% of the employee share and 1.5% of wages for income tax withholding. If you didn’t file the required 1099s, those rise to 40% and 3%. Intentional disregard loses the reduced rates entirely.

Say a business paid a worker $80,000 in a year and filed a 1099-NEC. The employer share of Social Security and Medicare is 7.65%, or $6,120. Twenty percent of the employee share adds $1,224, and 1.5% of wages adds $1,200. That’s $8,544 for one worker for one year, before federal and state unemployment tax, penalties and interest. Without the 1099, the same year is about $10,968.

Multiply that by several workers and three open years, then add state exposure, and the numbers get serious quickly.

Getting it right in practice

Review classification before the first payment, and again whenever a role changes. Contractor relationships tend to drift toward employment over time: more hours, more direction, fewer other clients.

• Check each contractor role against the IRS factors and the rules in every state where your workers are located.
• Let contractors decide how, when and where they work, use their own tools, and serve other clients.
• Where it fits the work, pay by project, milestone or invoice rather than by the hour on a schedule you set.
• Be cautious about converting departing employees into contractors who do the same job. It’s one of the clearest red flags an examiner sees.
• Collect a W-9, file 1099s on time, and keep contracts, invoices and evidence of each contractor’s independent business, such as a website, business license or insurance certificate.
• Treat similar workers consistently. Classifying two people doing the same job differently undermines your position for both.

Relief options if you got it wrong

If a situation is genuinely unclear, either you or the worker can file Form SS-8 to ask the IRS for a determination. The IRS says to expect at least six months for a response, so it isn’t a tool for quick decisions. A worker who believes they were misclassified can also file Form 8919 to pay their share of Social Security and Medicare, which often draws IRS attention to the payer.

Section 530 relief can protect a business from federal employment taxes if it had a reasonable basis for contractor treatment, treated all similar workers the same way, and filed all required 1099s. A reasonable basis can include court rulings, a prior IRS audit that didn’t reclassify similar workers, or a long-standing practice in your industry.

The Voluntary Classification Settlement Program lets eligible businesses reclassify workers going forward. You pay 10% of the employment tax liability for the most recent tax year, figured under the reduced section 3509(a) rates, with no interest or penalties on that amount and no employment tax audit of those workers’ classification for prior years. In the $80,000 example above, that’s about $854. You must have filed 1099s for those workers for the previous three years, can’t be under an IRS, Labor Department or state classification audit, and must file Form 8952 at least 120 days before you want to start treating the workers as employees.

State exposure is separate from federal relief, so a professional review of both before choosing a path is worthwhile. Tally Tax usually starts with the 1099 history and a role-by-role look at how each worker actually operates.

Frequently asked questions