Whether a business classifies a worker as an employee or an independent contractor isn’t a choice the business gets to make freely – it’s a legal determination governed by tests that vary between federal and state law, and getting it wrong exposes the business entity to back taxes, penalties, and benefits liability regardless of what the contract between the parties says.
The IRS Common Law Test: Control Is the Deciding Factor
For federal tax purposes, the IRS applies a common law test built around three categories: behavioral control (who directs how, when, and where the work gets done), financial control (who sets pay, covers expenses, and owns the tools), and the relationship of the parties (contracts, benefits, and whether the work is expected to be ongoing). No single factor is decisive – the IRS weighs the whole relationship – but the core question is always whether the business has the right to control how the work gets performed, not merely whether it does control it.
The ABC Test: Stricter, and Now Used by 16+ States
A growing number of states apply the ABC test instead of (or alongside) the federal common law test, and it’s meaningfully stricter: a worker is presumed to be an employee unless the business proves all three prongs – the worker is free from the business’s control in performing the work, the work is outside the business’s usual course of business, and the worker is engaged in an independently established trade of the same nature. Prong B is the one that catches businesses off guard most often: a driver working for a delivery company, or a stylist working for a hair salon, is doing work that’s central to that business’s usual operations, which can fail the ABC test even if the worker looks independent by every other measure.
Federal Classification Doesn’t Override State Classification
A worker who clearly passes the IRS common law test as an independent contractor can still be classified as an employee under a state’s ABC test – California’s AB5 and similar state laws apply their own standard for state-level purposes (unemployment insurance, workers’ comp, state wage law) regardless of how the same worker is treated federally. A business operating in an ABC-test state has to satisfy both standards, not just the federal one.
What Misclassification Actually Costs the Entity
Misclassifying an employee as a contractor exposes the business to back payroll taxes, unpaid overtime and minimum wage claims, unemployment insurance contributions, and workers’ compensation premiums the business should have been paying all along – plus penalties layered on top once a state agency or the IRS reclassifies the relationship after the fact. This liability attaches to the business entity itself, which is one more reason entity structure and workforce classification decisions aren’t separate questions – a business with real contractor-misclassification exposure needs the liability shield of a properly maintained LLC or corporation more, not less.
The Contract Doesn’t Settle the Question
Labeling someone a “1099 contractor” in a written agreement has no legal effect if the actual working relationship meets the legal test for employee status – courts and agencies look at how the relationship functions in practice, not what the paperwork calls it.
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Related reading: General Partners vs. LLC Members: Self-Employment Tax and Professional Employer Organizations (PEO).
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