Employee or Contractor? Getting Classification Right
How the IRS and states decide who is an employee, and what it costs to get it wrong.
Paying someone as a contractor feels simpler. No payroll taxes, no workers' comp, no W-2s. Many owners start that way, especially when the work is part-time or project-based.
But the label is not your choice to make. The IRS, the Department of Labor, and your state each have tests, and they look at the real working relationship. Getting it wrong can mean back taxes, penalties, and claims from the worker years later.
The IRS common-law test
The IRS asks one big question: does the business have the right to control what work is done and how it is done? To answer it, the IRS groups the evidence into three categories. No single factor decides the case; the whole picture matters.
| Category | Points toward employee | Points toward contractor |
|---|---|---|
| Behavioral control | You set hours, methods, and training | They decide how to get the result |
| Financial control | You supply tools; hourly pay; no chance of loss | They invest in tools, set prices, can profit or lose |
| Relationship | Ongoing, core to your business, gets benefits | Defined project, offers services to others |
State ABC tests are stricter
Several states use an ABC test for some or all purposes. Under California's version, codified by Assembly Bill 5 (AB5) in 2019, a worker is an employee unless the business shows all three: (A) the worker is free from the business's control, (B) the work is outside the usual course of the business, and (C) the worker is customarily engaged in an independently established trade or business.
Part B trips up many owners. A salon that hires a stylist, or a plumbing company that hires a plumber, will struggle to show the work is outside its usual business. California's law includes exemptions for certain occupations, so check the specifics with your state or an employment attorney.
Myth or fact? Tap to flip
What misclassification costs
If a worker is reclassified, you may owe the employer and employee shares of Social Security and Medicare you did not withhold, unemployment taxes, interest, and penalties. States can add their own assessments, and the worker may claim overtime, minimum wage, or benefits they should have received.
If you have a gray-area worker
You can ask the IRS for a determination with Form SS-8, though it takes time. Many owners find it faster to talk with an employment attorney or tax pro. If you discover past misclassification, the IRS Voluntary Classification Settlement Program may reduce what you owe.
1099-NEC basics for 2026
When you pay a genuine contractor (not a corporation, in most cases) for services in your business, you report it on Form 1099-NEC. For decades the threshold was $600. Legislation passed in 2025 raised it to $2,000 for payments made in 2026, with inflation adjustments starting in 2027.
Collect a Form W-9 from every contractor before you pay them, so you have their correct name and taxpayer ID. A contractor under the threshold still owes tax on that income; the change only affects your filing duty.
Owner story
Andre paid three painters as contractors because they preferred it. After learning that painting was squarely his core business under California's ABC test, he moved them to payroll. His costs rose, but he priced the change into his bids and stopped worrying about an audit or a claim.
Illustrative composite, not a real customer.
Quick check
A bakery hires a baker who works set shifts, uses the bakery's ovens and recipes, and has no other clients. How would most tests classify the baker?
Words to know
- Common-law test
- The IRS approach that weighs behavioral, financial, and relationship factors to decide worker status.
- ABC test
- A stricter state test that presumes a worker is an employee unless three conditions are met.
- Form 1099-NEC
- The form used to report payments of $2,000 or more (for 2026) to nonemployee service providers.
- Form W-9
- A form a contractor gives you with their legal name and taxpayer ID.
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