Employee or Independent Contractor? A Practical Classification Check for Small Businesses

Kelly Murphy

5 days ago

7 min read

Updated: 2 days ago

A worker is an independent contractor only when the way the work actually happens shows they run their own business. A 1099 form or a signed contract does not decide it, and the IRS, the Department of Labor, and your state each use their own test.

Many small businesses bring on help as a “1099 contractor” because it feels simpler: no payroll setup, no benefits, no handbook acknowledgment. Sometimes that’s exactly right. Sometimes it isn’t, and the cost shows up later.

The Department of Labor is clear on this point. Paying someone on a 1099, or having them sign an independent contractor agreement, does not by itself make them an independent contractor under federal wage law (DOL Fact Sheet 13).

Here’s a practical way to check your arrangements, what the rules look like as of October 2026, and what to do if something doesn’t fit.

Why classification matters

When someone who should be an employee is treated as a contractor, the business can end up responsible for things it never planned for, such as:

Unpaid minimum wage or overtime under federal and state wage laws
Employment taxes that should have been withheld and paid
State unemployment insurance and workers’ compensation coverage
Benefits and leave the worker may have been eligible for

The exposure depends on your state, how long the arrangement has been in place, and how many people are involved. The earlier you catch it, the easier it is to fix. The DOL’s misclassification page explains the federal wage side in more detail.

There isn’t just one test

This is what trips up most business owners. Different agencies use different tests, and a worker can be a contractor under one and an employee under another. Three matter for most small businesses.

1. The IRS test (federal taxes)

The IRS uses common-law rules and looks at the whole relationship, grouped into three categories:

Behavioral control: whether the business has the right to direct and control what work is done and how, through instructions, training, or other means.
Financial control: whether the business controls the business side of the job, such as how the worker is paid, whether expenses are reimbursed, and who provides tools and supplies.
Relationship of the parties: written agreements, employee-type benefits, how permanent the relationship is, and whether the work is a key part of the business.

The IRS explains these factors in Topic 762. If you want a formal answer, you or the worker can ask the IRS to decide by filing Form SS-8.

2. The Department of Labor test (wages and overtime)

Under the Fair Labor Standards Act, the question is economic reality: is the worker truly in business for themselves, or economically dependent on your business for work?

The federal standard is in transition. A 2024 DOL rule weighs six factors, with no single factor controlling. In May 2025, the DOL told its investigators it would no longer apply that rule in enforcement (Field Assistance Bulletin 2025-1). Then, on February 26, 2026, it proposed a new rule built around two core factors:

How much control the worker has over the work
The worker’s opportunity for profit or loss based on their own initiative or investment

Skill, permanence of the relationship, and whether the work is part of an integrated unit of production would be secondary factors. The proposal also says what actually happens matters more than what a contract says is possible.

As of late October 2026, the DOL has not published a final rule, so the 2024 rule technically remains on the books. Because this is changing, check the DOL’s rulemaking page before relying on any one version.

3. Your state’s test

States set their own rules for unemployment insurance, workers’ compensation, and state wage laws, and many are stricter than the federal tests. Some use an “ABC test,” which presumes a worker is an employee unless the business can show all three of the following:

The worker is free from the business’s control and direction, both in the agreement and in practice.
The work is outside the usual course of the business.
The worker is customarily engaged in an independently established trade, occupation, or business of the same kind.

California built this test into law in 2020 (California Labor Commissioner FAQ), and New Jersey adopted regulations clarifying its ABC test in 2026 (NJ Department of Labor). Even within one state, the test can differ between unemployment, workers’ compensation, and wage claims. If you have workers in more than one state, check each one. The DOL’s directory of state labor offices is a good place to start.

The second condition is where many small businesses get caught. If a marketing agency uses a “contract” graphic designer to do client design work every week, that work sits squarely within the agency’s usual business.

A practical classification check

Use these questions for each person you pay as a contractor. Answer based on what actually happens day to day, not just what the agreement says.

Who decides how, when, and where the work gets done?
Do you train this person or give detailed instructions on how to do the work?
Is the work part of what your business normally does or sells?
Does the person run their own business, with other clients, their own tools, and their own business name or insurance?
Can they make or lose money based on their own decisions, like how they price, whether they hire help, or what they invest?
Are they paid by the project or invoice, or by the hour on a schedule you set?
Is the relationship open-ended, with no defined project or end date?
Do they receive anything that looks like an employee benefit?
Did they previously do the same work for you as an employee?
Do they supervise your employees, or work alongside them doing the same tasks?

No single answer settles it. But if several answers point toward your control, ongoing work, and work that’s core to your business, treat that arrangement as one to review.

Situations that commonly raise questions

An office assistant paid on a 1099 who works set hours at your location, using your systems
A former employee brought back as a “consultant” to do the same job
A contractor who supervises your staff or is treated like a manager
A long-term part-time helper who has never invoiced anyone else

Compare that with a bookkeeper or IT provider who serves several clients, sets their own hours and methods, invoices you, and uses their own equipment. That arrangement is much more likely to hold up as a contractor relationship, though it still depends on the facts and your state.

What to do if something doesn’t fit

Don’t make a quick switch without a plan. Changing someone’s status affects pay, taxes, benefits, and possibly past liability.
Gather the facts. Pull together the agreement, invoices or payment records, schedules, who supervises the work, and how long it has been going on.
Talk with your CPA or an employment attorney before you reclassify, especially if the arrangement has been in place for a while or involves several people. If you’re not sure who to call first, see HR Consultant or Employment Attorney? Knowing Who to Call.
Ask about the IRS Voluntary Classification Settlement Program. Employers that have consistently treated the workers as contractors, including filing Forms 1099 for the previous three years, and are not under an IRS or DOL audit on classification may be able to reclassify the workers going forward. The employer pays 10 percent of the employment tax liability for the most recent tax year, figured at reduced rates, with no interest or penalties on that amount. The application, Form 8952, is due at least 120 days before the reclassification date. This is a federal employment tax program only, so it does not cover state taxes or wage claims (IRS VCSP).
Onboard reclassified workers like any new employee: Form I-9, tax withholding forms, state new-hire reporting, workers’ compensation and unemployment coverage, and any benefits they’re eligible for. Our onboarding guide walks through the steps.
For contractors you keep, make sure the written agreement matches how the work really happens, and review your arrangements once a year.

Frequently asked questions

What is the difference between an employee and an independent contractor?

An employee works under your direction and control, and you handle tax withholding, payroll taxes, and required coverage. An independent contractor runs their own business, decides how the work gets done, can make or lose money based on their own decisions, and invoices you for the work. Each agency applies its own test, so the answer can differ for taxes, wages, and unemployment.

Does a 1099 or a signed contract make someone an independent contractor?

No. The Department of Labor states that being paid on a 1099, or signing an independent contractor agreement, does not by itself make a worker an independent contractor under the FLSA (DOL Fact Sheet 13). What matters is how the working relationship really operates.

Can someone be an independent contractor for the IRS but an employee under state law?

Yes. Federal tax, federal wage law, and state unemployment, workers’ compensation, and wage laws each use their own test. A worker can pass one and fail another, so check the rules in each state where you have workers.

What should I do if I think I have classified someone incorrectly?

Gather the agreement, payment records, schedules, and details about who directs the work. Then talk with your CPA or an employment attorney before changing anything, and ask whether the IRS Voluntary Classification Settlement Program fits your situation.

How I can help

Worker classification is one of the areas I look at in the HR Diagnostic, along with policies, documentation, and other HR compliance gaps. I’ll help you sort out which arrangements look solid, which ones raise questions, and what to address first. When something needs a legal opinion, I’ll tell you, so you can bring in an employment attorney with the facts already organized.

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