The test is control
The IRS’s common-law test asks whether the company has the right to direct and control the work, not just its result. It groups the evidence in three kinds:
No single factor decides it. Several states are stricter. California, since its AB 5 law of 2019, applies an ABC test for most purposes: a worker is an employee unless (A) they are free from your control, (B) the work is outside the usual course of your business, and (C) they run an independent business of that kind. A software engineer building your product fails B on its own. Massachusetts and New Jersey use ABC tests too, and many more states use one for unemployment insurance. Where the person works decides which state’s rule applies.
Federal wage-and-hour law adds a third view. The Department of Labor decides who is owed minimum wage and overtime with an “economic reality” test. It stopped enforcing its 2024 rule in May 2025 and in February 2026 proposed replacing it with a test centered on control and the worker’s opportunity for profit or loss; until a final rule is published, check the current status rather than relying on either. Passing one test doesn’t mean passing the others.
- Behavioral control: who decides how, when and where the work is done, and who trains the person.
- Financial control: who provides the tools, who can make or lose money on the engagement, whether they work for others.
- The relationship: benefits, how long it’s expected to last, and whether the work is a core part of the business.
- BehavioralSets their own hours and methodsYou set the hours, the methods and the training
- FinancialOwn tools, other clients, can profit or loseYour equipment, your only client, paid for time
- The relationshipA defined project with an endOngoing, core to the business, with benefits
- W-9 before the first payment
- Invoices, tagged to the person
- 1099-NEC by January 31
- Withholding and employer payroll taxes
- Registered in the state they work from
- Quarterly returns and a W-2
What an employee changes
An employee means payroll: income tax and FICA withheld from each paycheck, employer Social Security, Medicare and unemployment taxes on top, quarterly returns and a W-2 each January. It also means registering in the state where the person works: a withholding account, an unemployment insurance account and, often, qualifying the company to do business there. A first remote hire in a new state is the moment to do all three, before the first paycheck.
A contractor means a W-9 before the first payment, invoices, and a 1099-NEC by January 31. The difference in cost is real, which is exactly why misclassification is audited.
The cost of getting it wrong
A misclassified worker can mean back employment taxes, both halves, with penalties and interest; state unemployment and workers’ compensation assessments; and claims for overtime or benefits the person should have had. It also shows up in diligence, because the request list asks for every contractor, what they do and how long they’ve been doing it.
When a role becomes permanent, convert the person to payroll on a date, from that date forward, with an offer letter and, if there is one, an option grant recorded on the cap table. If you’re unsure, a CPA or employment lawyer can review it; the IRS will also give a determination on Form SS-8, slowly.
For a company that has already treated a group of workers as contractors, the IRS’s Voluntary Classification Settlement Program offers a way out: reclassify them as employees going forward and pay 10% of one year’s employment tax liability, computed at reduced rates, with no interest or penalties. It needs Form 8952, filed at least 120 days before the switch and while no IRS, Department of Labor or state classification audit is open, and 1099s filed for those workers for the previous three years. It settles federal employment tax only, not state claims.
On your books
Contractor spend and payroll go to different accounts, and both go to the department the work is for, so the burn rate by function is right. Payroll ties to the provider’s register every month, including employer taxes. Contractor payments are tagged to the person, which is what makes the 1099s, the R&D credit and a classification review possible from the same records.
Common questions
If we sign a contractor agreement, is the person a contractor?
No. The label in the agreement is one fact among many. The IRS looks at who controls how the work is done, who controls the business side of it, and what the relationship looks like in practice. A contractor who works set hours, on your equipment, under a manager, on core work with no end date, may be an employee whatever the contract says.
What paperwork does a contractor need?
A US contractor gives you a Form W-9 and gets a 1099-NEC if you pay them $2,000 or more in the year ($600 for payments made in 2025). A contractor abroad who isn’t a US person gives you a Form W-8BEN instead, and generally gets no 1099. Either way, the payments are tagged to the person in your books all year.
What about contractors in other countries?
US payroll law generally doesn’t reach someone who isn’t a US person working outside the US, but their own country’s employment law does, and many countries have their own misclassification tests. A long-term, full-time contractor abroad is often hired properly through an employer of record, which employs them locally on your behalf.
Does paying less than the 1099 threshold make someone a contractor?
No. The 1099 threshold decides whether you report the payments, not whether the person is a contractor. Someone paid $1,500 can be an employee; someone paid $300,000 can be a genuine contractor. Classification is about control, and the threshold only about paperwork.
Terms in this guide
Each one has its own page in the founder glossary. Hover for the short version, or open the full entry.
Keep going
From here: the lesson behind it and the state guides that cite it.
- Lesson 2 · 7 minThe accounting equationAssets = liabilities + equity is not a formula you apply at period end. It is true after every single entry, and that is what makes the books provable.
- State guides · cited in 51 statesFederal payables for startupsFederal payables work is information reporting: a W-9 or W-8 from every vendor, 1099-NEC at the new $2,000 threshold, backup withholding at 24% when a TIN is missing, and electronic filing through IRS IRIS once you have 10 returns.
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General information for US companies, not tax, legal or accounting advice for yours. Rules and thresholds change; confirm the specifics with a CPA before you act on them.