Employee or Independent Contractor? How Startups Get Worker Classification Wrong and What It Costs
One of the most common questions that come up us in advising new startups about how to scale comes when they are looking to onboard a team. No one wants to pay employment taxes, and its common to call someone a 1099 contractor when they are not.
So, how do we think about this problem?
First, its worth pointing out that calling someone an independant contractor does not make it so. There are tests that different jurisdictions use to decide whether the arrangement you have makes someone an employee or a contractor.
Even a signed agreement declaring someone an independent contractor does not make them one. If the facts say employee, the government and the courts will say employee, and they will say it retroactively, with interest.
Further, different jurisdictions use different tests, and the same worker can be a contractor under one and an employee under another at the same time. Here is the map.
If you are operating in California, I’ve got bad news. California has one of the most stringent tests for determining the status of a worker. They follow what is called the ABC test. New Jersey, Massachusetts and about twenty other states follow some version of the ABC test.
New York follows the traditional control test, which is significantly easier to navigate. The control test asks who controls the means and method of work. Texas and Florida also follow this track.
And, of course, the federal applies several different tests depending on the context.
See below for summaries of beach of these tests.
The ABC test: the strict one
Under the ABC test, every worker is presumed to be an employee. The company can rebut that presumption only by proving all three prongs:
A. The worker is free from the company's control and direction in performing the work, both under the contract and in fact.
B. The work performed is outside the usual course of the company's business.
C. The worker is customarily engaged in an independently established trade, occupation, or business of the same kind.
For example, if you run a software company and you hire a freelance developer to build your product, that work is squarely inside your usual course of business, and prong B fails no matter how independent the developer is. The bookkeeper you hire, on the other hand, may pass.
New Jersey applies an ABC test as well, and its version of prong B can also be satisfied if the work is performed outside all of the company's places of business. Massachusetts has one of the strictest versions in the country. More than twenty other states use some form of ABC test, in many cases just for unemployment insurance purposes rather than across the board.
The common-law control test: the traditional one
The common-law test asks one central question: does the company have the right to control not just the result of the work, but the manner and means by which it gets done? Courts weigh factors like who sets the hours, who provides the tools, whether the worker can take other clients, how the worker is paid, and how integrated the role is into the business. No single factor decides it.
The common-law test is more forgiving than ABC because there is no automatic prong B failure for core-business work, but a founder who directs a "contractor" like an employee will still lose.
The economic realities test: the dependence one
The economic realities test asks whether the worker is, as a matter of economic fact, in business for themselves or dependent on the company for their livelihood. Factors include the worker's opportunity for profit or loss, their investment in their own equipment and business, the permanence of the relationship, the degree of control, whether the work is integral to the business, and the worker's skill and initiative.
This is the test under the federal Fair Labor Standards Act, which governs minimum wage and overtime, and some states borrow it or blend it with control factors.
Yes, there is a federal test. Actually there are several.
The federal government does not speak with one voice on this.
The IRS uses a common-law test for employment tax purposes, historically expressed as twenty factors and now grouped into three categories: behavioral control, financial control, and the relationship of the parties. A company that wants certainty can ask the IRS directly for a determination on Form SS-8.
The Department of Labor uses the economic realities test for wage-and-hour claims under the FLSA. The DOL issued a six-factor rule in 2024, then announced in a 2025 field assistance bulletin that its investigators would not apply that rule in enforcement while the agency reconsiders it. The standard is in flux, which is a reason for caution, not comfort.
The National Labor Relations Board applies its own common-law analysis to decide who counts as an employee with organizing rights under federal labor law.
The practical takeaway: your developer can be a legitimate contractor to the IRS and simultaneously a misclassified employee under California wage law. Passing one test is not a defense to failing another. You have to clear the strictest test that applies to your worker, and that usually depends on where the worker lives and works, not where your company is incorporated.
What it costs when you get it wrong
Problems most often arise when a contractor is let go and files for unemployment, gets hurt and files a workers' compensation claim, or talks to a lawyer about unpaid overtime. Any one of those can trigger an audit that sweeps in every contractor you have ever paid.
The bill can include back federal and state employment taxes the company should have withheld and paid, plus penalties and interest. Unpaid minimum wage and overtime, which under the FLSA can be doubled as liquidated damages, going back two or three years. Retroactive unemployment and workers' compensation contributions. Claims for the value of benefits the worker would have received as an employee. And in some states, statutory penalties per misclassified worker on top of everything else.
There is also an IP angle startups overlook. As covered in our post on who owns your startup's code and logo, work-for-hire rules operate differently for employees and contractors. A misclassification mess and an IP ownership mess frequently arrive together, usually during diligence for a financing or acquisition, which is the worst possible time.
The checklist before your first hire
Before you engage anyone as a 1099 contractor, run through this honestly:
Identify the tests that apply based on where the worker lives and works, and measure against the strictest one.
Ask the prong B question: is this work my actual product or service? If yes, and an ABC state is involved, lean strongly toward employee.
Confirm the contractor runs a real business: their own entity or trade name, their own equipment, their own insurance, and ideally other clients.
Pay by project or deliverable where possible, not by the hour on a fixed schedule.
Do not direct the how. Define the result, the deadline, and the price, and let them decide the manner and means.
Skip the trappings of employment. No company email address, no title on the org chart, no standing meetings they are required to attend, no company laptop.
Get a written agreement that matches the reality above, and make sure it includes a present-tense IP assignment.
If the role is full-time, indefinite, and central to the business, stop trying to make contractor work. Put them on payroll. Payroll services make this far less painful than founders fear.
When the answer is genuinely unclear, get advice before the engagement starts. Reclassifying someone later is expensive. Being reclassified by an auditor is worse.
Better yet, talk to an experienced lawyer who has handled these kinds of issues. We happen to know several.
TL/DR
Classification is decided by legal tests, not by your contract. The ABC test used in states like California, New Jersey, and Massachusetts presumes employment and is very hard to satisfy for core-business work. New York and others use a control test. The federal government applies several tests of its own, and the DOL's current standard is in flux. Passing one test does not mean passing them all. Misclassification costs back taxes, double damages on unpaid overtime, and penalties, and it tends to surface during fundraising or exit diligence. When a role is core, full-time, and ongoing, hire an employee.
This post is general information, not legal advice, and does not create an attorney-client relationship. Classification rules are fact-specific, vary by state, and change. Talk to counsel about your situation.