Hiring new staff is a big step for any small business.
There may be times, though, when hiring an independent contractor may make more sense than hiring an employee, especially if there are specialized projects your business is doing that may not require full-time or permanent work. Hiring a contractor can help you stay competitive without overextending your time, budget or team.
But before you decide, it’s critical to understand the legal rules behind worker classification. Misclassifying a worker can – and does! – lead to back wages, tax penalties, fines, and legal claims. The good news? With the right tests and a thoughtful review, small businesses can reduce risk and make informed decisions.
Why Worker Classification Matters
How a worker is classified affects:
- Payroll taxes and reporting
- Minimum wage and overtime requirements
- Workers’ compensation and unemployment insurance
- Eligibility for benefits
- Legal exposure and audits
Independent contractors are generally not entitled to wage-and-hour protections, while employees are. Because of this, government agencies closely scrutinize classifications.
The core rule is that it’s NOT about the title. Calling someone a “contractor,” sending them a 1099, or having them sign an agreement does NOT automatically control their status. What really matters is the reality of the working relationship. How is the work performed day to day?
The Primary Test: The Economic Reality Test
At the federal level, the Department of Labor applies what’s known as the Economic Reality Test. Small businesses should review each of the following factors together, no single factor decides the outcome.
1. Who Controls the Work?
- Do you set the worker’s schedule or do they?
- Do you tell them how, when, and where to do the work? Are they required to work set hours?
- Do you supervise them closely?
The more control you have over an individual working in your business means they are more likely to be classified as an employee. Independent contractors typically decide how and when the work gets done.
2. Can the Worker Make a Profit or Suffer a Loss?
- Can the worker negotiate their rate?
- Do they manage expenses?
- Can they lose money if the job costs more than expected?
- Are they paid per project, or hourly or weekly like staff?
- Can the worker earn more by working more efficiently?
True contractors operate like a business, not just someone trading time for pay. If you answered no to the above questions, it is more likely you would pay your person as an employee since you are the one who controls more of the above as the business owner.
3. Who Invests in Tools and Equipment?
- Who provides tools, software, vehicles, or equipment? Do they use company email, tools or systems?
- Does the worker have their own business expenses?
- Does the worker carry business insurance?
- Has the worker made meaningful business investments?
If the worker makes meaningful investments in their own business, that points toward contractor status. When you are providing items that the worker uses on a regular basis (computer, office supplies, printers, etc.) they would more than likely be paid as an employee.
4. How Permanent Is the Relationship?
- Is the relationship with the worker project-based or open-ended?
- Is the worker free to work for others?
- Do you expect this arrangement to last indefinitely?
- Is there an exclusivity agreement?
- Is the worker free to market services to the public outside of their obligation to you?
Long-term, exclusive relationships often signal employee status. Contractors often work with multiple businesses on different projects and tend to have a more project-based relationship with you.
5. Is the Work Central to Your Business?
- Is this work a core part of what your business offers?
- Could your business operate without this role?
- Does the worker represent your company publicly?
- Is this worker listed on internal org charts?
- Does this worker manage other employees?
If the worker performs essential, ongoing business functions and you answer yes to most of the above bullet points, they’re more likely an employee. Contractors, on the other hand, tend to work on specialized items in your business that they focus on.
6. Does the Work Require Specialized Skill and Independence?
- Does the worker bring specialized expertise?
- Do they operate independently without training from you?
- Do they have multiple clients?
- Does the worker have a business name or entity?
- Does this worker invoice for the services they perform for your business?
If you answer yes to many of the above bullet-points, you more than likely would consider your worker an independent contractor.
Additional Tests Small Businesses Should Know
1. The IRS Common Law Test
The IRS focuses on:
- Behavioral control
- Financial control
- Relationship of the parties
This test affects tax liability and reporting obligations. Depending on the answers on the bullet points above, it will more than likely be clear which direction you should go when preparing to pay a worker.
2. State Law Tests (Very Important!)
Many states apply stricter rules than federal law. For example, some use an “ABC test,” which assumes a worker is an employee unless all criteria are met. Always check state and local law, especially if you operate in multiple states, to ensure you are following the rules appropriately.
3. Practical Checklist for Small Businesses
Before paying someone as an independent contractor, ask:
- Do they have their own business, website, or clients?
- Can they refuse work or set their own schedule?
- Are they paid per project, not hourly?
- Do they invoice you?
- Do they carry their own insurance?
- Can they hire helpers or subcontract work?
If most answers are “no,” you should seriously reconsider contractor status. This worker would more than likely be considered an employee of your small business.
4. Common Mistakes Small Businesses Make
- Paying someone as a contractor “to save money”
- Classifying long-term workers as contractors
- Treating contractors like employees day-to-day
- Assuming a signed contract overrides the law
- Ignoring state-specific rules
Final Thoughts
Classifying workers correctly isn’t about red tape, it’s about protecting your business and treating workers fairly. A little upfront diligence can prevent costly mistakes later. When in doubt, erring on the side of employee status or getting professional advice can save significant time, money, and stress down the road!