Contractor or Employee? How to Classify a Worker

Why the label matters

For an employee, you withhold income tax, withhold and pay Social Security and Medicare taxes, and pay federal unemployment tax. For an independent contractor you generally do none of that. Employees are also covered by federal minimum wage and overtime rules, and by state wage, leave and workers' compensation laws.

Calling someone a contractor does not make them one. The IRS says that if you treat an employee as a contractor without a reasonable basis, you can be held liable for the employment taxes on that worker. States add their own penalties. California, for example, sets civil penalties of $5,000 to $15,000 per violation for willful misclassification, and $10,000 to $25,000 per violation where there is a pattern or practice.

The IRS test: who controls the work

For federal employment taxes, the IRS uses the common-law rules and groups the evidence into three categories. No single fact decides; you look at the whole relationship.

Behavioral control: does your company control, or have the right to control, what the worker does and how they do it? Detailed instructions, required methods and training on how you want the work done point toward employee.
Financial control: who controls the business side of the job? Look at how the worker is paid, whether expenses are reimbursed, and who provides tools and supplies.
Type of relationship: is there a written contract, are there employee-type benefits such as insurance or paid time off, will the relationship continue, and is the work a key part of your regular business?

The Department of Labor test: economic reality

For minimum wage and overtime under the Fair Labor Standards Act (FLSA), the question is whether the worker is economically dependent on your business or is in business for themselves. The federal rule is in the middle of a change, so here is where it stands as of October 2026:

A 2024 DOL rule (29 CFR Part 795, in effect since March 11, 2024) sets out a six-factor test. The DOL's rulemaking page still lists it as the rule in effect.
On May 1, 2025, the DOL's Wage and Hour Division said in Field Assistance Bulletin 2025-1 that its investigators would stop applying the 2024 rule and would instead use Fact Sheet #13 (July 2008) and Opinion Letter FLSA2019-6. The same bulletin says the 2024 rule remains in effect for private lawsuits.
On February 26, 2026, the DOL proposed a new rule to replace the 2024 rule, covering the FLSA, the Family and Medical Leave Act (FMLA) and the Migrant and Seasonal Agricultural Worker Protection Act. Comments closed on April 28, 2026. Check the DOL rulemaking page for whether a final rule has been issued.

Under every version, the factors overlap. The 2008 fact sheet the DOL now enforces lists: how integral the work is to your business, how permanent the relationship is, the worker's investment in facilities and equipment, the nature and degree of your control, the worker's opportunity for profit or loss, the initiative and judgment needed to compete in the open market, and how independently the worker's business is organized. It also says some facts do not matter, such as where the work is done, the absence of a formal agreement, whether the worker holds a state or local license, and how or when they are paid.

State ABC tests

Some states use a stricter test that starts from the assumption that a paid worker is an employee. California's version, in Labor Code section 2775 (the law known as AB 5), says a person is an employee unless the hiring business shows all three of these:

A: the person is free from your control and direction in doing the work, both under the contract and in fact.
B: the person does work outside the usual course of your business.
C: the person is customarily engaged in an independently established trade, occupation or business of the same kind as the work.

California's Labor and Workforce Development Agency notes that part C is not met just because you call someone a contractor or make a contractor agreement a condition of the work. The law has exceptions for some occupations and relationships, so check whether one applies before relying on it. New Jersey also applies an ABC test, including under its unemployment, wage and hour, and wage payment laws.

The same person can pass the IRS test and fail a state test. Use the strictest test that applies where the person works. See California and New Jersey.

Not sure? Get a ruling or fix it

Form SS-8: either your business or the worker can ask the IRS to decide the worker's status for federal employment taxes. The IRS says a determination usually takes at least six months.
Voluntary Classification Settlement Program: eligible businesses can start treating workers as employees going forward with partial relief from past federal employment taxes, by filing Form 8952.
Reasonable-basis relief: the IRS describes relief for businesses that had a reasonable basis for contractor treatment and filed the required information returns consistently.

If you convert a contractor to an employee, treat it as a new hire: Form I-9, Form W-4, a state new-hire report and payroll setup. See how to hire your first employee.

Warning signs you have an employee

You set their hours, review how they do the work, or train them in your methods.
They use your laptop, accounts and tools, and you reimburse their expenses.
The work is ongoing with no end date, and it is the core of what your company sells.
They work only for you and do not market their services to others.
They are paid by the hour or week with no real chance of profit or loss.
They do the same job as people you already treat as employees.

Common questions

Does a signed contractor agreement make someone a contractor?

No. The IRS, the DOL and state tests all look at how the relationship works in practice. California says a contractor label set by the business does not by itself satisfy part C of its ABC test.

Can a worker be a contractor for the IRS but an employee under state law?

Yes. The tests are different, and states like California and New Jersey use a stricter ABC test. Follow the strictest test that applies where the person works.

How long does an IRS Form SS-8 determination take?

The IRS says at least six months, so it is not a quick fix for a decision you need to make now.

How MambaHR handles this

MambaHR answers classification questions with the federal and state law cited, and unclear cases go to a person to decide. When you bring someone on as an employee, it sends the new-hire forms, starts the Form I-9, and turns the hire into a payroll change for a person to approve.

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Sources

Last reviewed October 2, 2026. This page is general information, not legal advice. Laws change and exceptions apply, so check the sources above or an employment lawyer before you act on a specific case.