Classifying a worker as an independent contractor when they should be an employee is not just a paperwork issue—it is a liability that can bankrupt a small business. Back payroll taxes, penalties, state fines, and retroactive benefits obligations can add up to several years' worth of the savings the misclassification was intended to generate.
The IRS Test
The IRS uses a multi-factor "common law" test to determine worker classification. The three key dimensions are behavioral control (does the company control how work is done?), financial control (does the company control the business aspects of the worker's job?), and the type of relationship (are there written contracts, employee benefits, and is the relationship permanent?).
State Tests Are Often Stricter
California, Massachusetts, and several other states use the ABC test, which is more restrictive than the IRS test. Under the ABC test, a worker is presumed to be an employee unless the hiring entity can prove: (A) the worker is free from control, (B) the work is outside the company's usual business, and (C) the worker is engaged in an independently established trade.
Key Takeaways
- Misclassification penalties include back payroll taxes, penalties, interest, and retroactive benefits—often several times the original "savings."
- California, Massachusetts, and others use the ABC test, which is harder to satisfy than the IRS test.
- If a worker fails any prong of the applicable test, reclassify proactively—the cost is far lower than an audit.
