If you’re a small business owner, hiring help is often a sign of growth. But before you onboard someone to support your business—whether for bookkeeping, marketing, construction, or delivery—there’s an important legal distinction you must make: are they an employee or an independent contractor?
Classifying a worker correctly isn’t just a formality. It affects how you handle taxes, payroll, liability, benefits, and legal compliance. Misclassification—whether accidental or intentional—can lead to serious financial and legal consequences, including back taxes, penalties, and even lawsuits.
At Brodersen Law, we’ve seen how common this mistake is, especially among small businesses and startups. Here’s what every business owner needs to understand about the legal differences between employees and independent contractors—and how to protect your business by getting it right from the start.
Why Classification Matters
From a legal standpoint, employees and independent contractors are fundamentally different. Employees are covered by labor laws, which provide protections like minimum wage, overtime, unemployment insurance, and workers’ compensation. Employers are responsible for withholding taxes, providing benefits (if applicable), and following strict employment regulations.
Independent contractors, on the other hand, are self-employed. They handle their own taxes, insurance, and business expenses. They’re not covered by most labor laws and typically don’t receive benefits. Because they operate independently, they’re generally hired for specific tasks or projects, not as ongoing staff.
When you misclassify an employee as an independent contractor, you may avoid certain payroll costs and legal responsibilities in the short term—but you’re exposing your business to audits, fines, and possible litigation.
The Legal Tests for Worker Classification
There’s no single rule that applies in every case, but several legal frameworks are commonly used to determine a worker’s classification. These include federal standards (such as those from the IRS and the Department of Labor) and state-specific rules, which can vary widely. Here are the main factors courts and agencies consider.
Control and Independence
This is the central issue: how much control does the employer have over how, when, and where the work is done?
- If the worker sets their own schedule, chooses how to complete tasks, and uses their own tools or equipment, they are more likely to be considered an independent contractor.
- If the employer dictates the work process, hours, training, or supervises the day-to-day tasks closely, the worker is more likely an employee.
Financial Arrangement
How a worker is paid and how they handle their business expenses can also indicate their classification.
- Independent contractors typically invoice for their work, may charge by the project or hour, and cover their own costs (like software, tools, or travel).
- Employees are usually paid on a regular schedule (weekly or biweekly) via payroll and receive reimbursements or supplies from the employer.
Duration and Nature of the Relationship
The length and type of relationship matter, too.
- A short-term or one-time project is more consistent with an independent contractor.
- Ongoing, open-ended work relationships—especially where the worker performs a core function of the business—point to employee status.
Integration into the Business
Ask yourself: is this person doing work that is central to the business?
- If the worker provides services that are part of your business’s main offerings, they’re more likely to be seen as an employee.
- If their work is peripheral or specialized (e.g., a graphic designer hired for a one-time logo project), contractor status is more appropriate.
Common Misconceptions
Many business owners assume that using a contract, paying by the project, or calling someone a contractor on paper is enough to define the relationship. Unfortunately, what you call someone doesn’t determine their legal status—courts and government agencies look at how the relationship actually functions in practice.
Some business owners also think that if a worker prefers to be a contractor, it’s okay to classify them that way. But mutual agreement isn’t enough if the facts suggest an employee relationship.
Another common error: treating someone like a contractor to avoid paying taxes or benefits. This can backfire during a Department of Labor audit or if the worker later files for unemployment or workers’ comp—two benefits contractors aren’t eligible for. If a state agency determines the person was actually an employee, your business could be liable for back pay, taxes, penalties, and interest.
State-Specific Rules: Be Aware
Many states, including California, use the stricter “ABC Test” for classification. Under this test, a worker is presumed to be an employee unless the business can prove all three of the following:
A. The worker is free from control and direction in performing the work
B. The work performed is outside the usual course of the hiring entity’s business
C. The worker is customarily engaged in an independently established trade or occupation
Failing to meet just one of these conditions means the worker is an employee under state law—even if they meet federal criteria for a contractor.
This creates extra compliance challenges for businesses that operate in multiple states or hire remote workers. Brodersen Law can help you navigate both federal and state requirements and avoid misclassification risks.
How to Protect Your Business
The best protection is prevention. Here’s how you can minimize your legal exposure:
- Consult an attorney before classifying new workers or drafting contractor agreements
- Use a tailored, enforceable contract that defines the scope of work, payment terms, and clarifies that the worker is an independent contractor—if the classification is appropriate
- Avoid treating contractors like employees—don’t set fixed work hours, require them to use company equipment, or supervise their daily work
- Keep records and documentation of all contracts, communications, and payments
- Stay informed about law changes at both the state and federal level, especially as regulations continue to evolve around gig economy work
What to Do If You’ve Misclassified a Worker
If you realize you may have misclassified a worker, don’t panic—but don’t ignore it either. You may be able to resolve the issue by reclassifying the worker correctly going forward and working with a legal advisor to address past obligations.
In some cases, voluntary correction programs (like the IRS’s VCSP) allow employers to fix misclassification issues with reduced penalties. The key is to act quickly and seek legal guidance before a claim or audit hits your doorstep.
Final Thoughts
As a small business, your people are one of your greatest assets—but misclassifying them can quickly become a costly liability. The distinctions between employees and independent contractors may seem subtle, but they carry significant legal and financial consequences.
At Brodersen Law, we help businesses of all sizes get these decisions right. Whether you’re hiring your first contractor, building a team, or reassessing your workforce classifications, we’re here to provide practical, personalized legal advice. Avoiding misclassification isn’t just about compliance—it’s about protecting your business, your people, and your future.