This is one of the few areas where a small business can create a large, compounding liability without noticing. It is also one where the intuitive answer — "they agreed to be a contractor" — is simply not how the rules work.
The federal common-law test
The IRS assesses the degree of control and independence across three categories. No single factor decides it; the whole relationship is weighed.
| Category | Points toward employee | Points toward contractor |
|---|---|---|
| Behavioural control | You direct when, where and how the work is done; you train them; you set the sequence | They decide method and schedule; they bring their own expertise |
| Financial control | You supply tools and equipment; you reimburse expenses; they have no risk of loss | They have a significant investment, unreimbursed costs, can profit or lose, and market to others |
| Relationship | Indefinite duration; benefits; the work is core to your business | Engaged for a defined project; no benefits; the work is peripheral |
Whether the worker is doing work that is central to your business. A cleaning company engaging a cleaner is engaging someone to do the company's core work — that points strongly toward employment, however the arrangement is documented. A cleaning company engaging a bookkeeper is a very different case.
State tests can be stricter
Passing the federal test does not settle state law. A number of states apply an "ABC test" for unemployment insurance, wage law or both, under which a worker is presumed to be an employee unless the hiring entity establishes all three of:
- The worker is free from the control and direction of the hiring entity in performing the work.
- The work is outside the usual course of the hiring entity's business.
- The worker is customarily engaged in an independently established trade or business of the same nature.
Part B is the demanding one, and it is where many arrangements that pass the federal test fail. Because the elements are conjunctive, missing any one of them makes the worker an employee. Check your own state's test — the variation here is genuinely significant, and you can be a contractor federally and an employee under state law simultaneously.
What misclassification costs
- Back employment taxes — the employer share of Social Security and Medicare, plus amounts that should have been withheld.
- Federal and state unemployment tax for the whole period.
- Interest and penalties, which accrue from the original due dates.
- Unpaid overtime and minimum wage exposure under wage and hour law, potentially with liquidated damages.
- Workers compensation exposure — including an uninsured injury claim, which is the scenario that most often turns this from an accounting problem into a serious one.
- Retrospective benefit entitlements, depending on your plans.
Investigations frequently begin not with an audit but with a worker filing for unemployment after the engagement ends, which prompts the state to ask why no contributions were made.
If you are engaging a genuine contractor
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Put a real agreement in place
Defining the deliverable and the outcome rather than hours and supervision. The document does not decide classification, but it should at least be consistent with the reality.
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Collect a Form W-9 before paying
Getting the taxpayer identification number up front is far easier than chasing it in January.
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Let them control the how
Specify what is to be delivered and by when. Directing the method, the hours and the sequence is the behaviour that converts a contractor into an employee in substance.
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Ask for proof of their own business
Their own insurance, business licence, other clients, their own tools. This is the evidence that supports the classification if it is ever questioned.
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Issue Form 1099-NEC where required
For payments at or above the reporting threshold in a calendar year to unincorporated contractors, filed after year end. Check the current threshold, which has been subject to change.
If a classification is genuinely unclear, you can ask the IRS to determine it by filing Form SS-8. It is slow, and the determination is what it is — so it is worth taking advice before filing rather than treating it as a free second opinion.
If you have misclassified someone
Address it deliberately rather than quietly changing arrangements. The IRS operates a Voluntary Classification Settlement Program allowing eligible employers to reclassify workers prospectively with partial relief from back taxes. Eligibility conditions apply, and state exposure is separate and not covered by it. This is a situation to take professional advice on before acting.
Questions owners ask
They asked to be a contractor. Does that help?
No. Classification protections cannot be waived by agreement, and the worker's preference is not a factor in the tests. A worker who asked for contractor status can still file for unemployment later and trigger a review.
What if they work for other clients too?
It helps — it supports an independently established business — but it is one factor among many. Someone with several clients can still be your employee if you control how they do your work and it is central to your business.
Does paying through their LLC settle it?
Not by itself. Agencies look at the substance of the relationship. An entity in the middle is a factor, not a shield, and under a strict ABC test it does little on its own.
Can someone be part-time and still an employee?
Yes. Hours have nothing to do with classification. A few hours a week under your direction is a part-time employee, not a contractor.
Where to check
- IRS — independent contractor or employee
- DOL — misclassification
- IRS — Form SS-8
- Your state labour and unemployment insurance agency, for the test that applies locally