How do I convert a contractor to an employee?

Why would I convert a contractor to an employee?

The most common reason is that the relationship already looks like employment. Three tests matter. The IRS uses a common-law test that weighs behavioral control (do you direct how the work is done?), financial control (who provides tools, bears expenses and can make a profit or loss?) and the relationship itself (benefits, permanence, whether the work is central to your business). The Department of Labor applies an economic reality test under the Fair Labor Standards Act that asks whether the worker is economically dependent on you or in business for themselves. DOL stopped enforcing its 2024 version of that rule in 2025 and proposed a replacement in early 2026 that weighs control and opportunity for profit or loss most heavily, but courts apply the economic reality test either way. California's ABC test is the strictest: a worker is an employee unless they're free from your control, do work outside the usual course of your business and run an independently established business. A software engineer building your core product fails the second prong almost by definition. Several other states, including Massachusetts and New Jersey, use ABC tests for some purposes.

Misclassification exposes the company to unpaid payroll taxes, overtime, benefits claims and state penalties. Investors find it in diligence, usually by spotting a long-tenured "contractor" with a company email address and a title. And sometimes the person simply wants benefits and a long-term role. See Independent Contractor vs Employee.

What are the steps to convert a contractor?

Start with an offer letter that states the start date, salary, title, exempt or non-exempt status and equity, and says employment is at will. Leave out a probation period; at-will employment already lets either side end the relationship, and a probation period implies more protection afterward. See Exempt vs Non-Exempt.

Next, the CIIAA (Confidential Information and Invention Assignment Agreement). The contractor agreement's IP assignment stays in force for the work done under it, so pull the signed copy and check that it actually assigns, in present-tense words like "hereby assigns," all work product and inventions to the company. If there's no signed agreement, or it only promises to assign later, have the person sign a confirmatory assignment of all prior work, supported by some consideration, at the same time as the CIIAA. The CIIAA should cover everything from the start date forward and confirm that earlier work belongs to the company. See The CIIA Agreement.

Then the onboarding paperwork. The person completes Form I-9 with you by their third business day of employment, even though you've worked with them for a year. They complete a Form W-4 and any state withholding form, and you enroll them in payroll and benefits. If they live in a state where you have no other employees, you'll need to register there before the first payroll; see How Do I Hire Remote Employees in Other States? See also Employee Onboarding for Startups.

What happens to the contractor's equity?

Options granted to a contractor are nonqualified stock options (NSOs), because incentive stock options can only be granted to employees. Becoming an employee doesn't convert an existing NSO into an ISO. Under most equity plans, a move from consultant to employee doesn't break continuous service, so the existing options keep vesting on their original schedule.

New grants made after the conversion can be ISOs, which is the default for US employees. If you're adjusting the person's total equity at conversion, the board can make a new ISO grant at the current 409A price, and it can set the vesting commencement date back to the start of the contractor relationship to give credit for prior service. That's a board decision, not an entitlement, and it should be written into the approving consent. If the person held restricted stock as a contractor, it keeps vesting under its existing agreement. See NSO vs ISO.

Do I have to pay back taxes for the contractor period?

If the person was properly classified as a contractor, no. If they were really an employee, the company may owe the employer and employee shares of Social Security and Medicare tax, federal income tax withholding and unemployment taxes for the past period, plus interest and penalties, and states can assess their own amounts.

The IRS offers the Voluntary Classification Settlement Program (VCSP) for this situation. Mechanically, a company that has consistently treated the workers as contractors, filed Forms 1099 for them for the previous three years and isn't under an employment tax audit (or a DOL or state audit on classification) can agree to treat them as employees going forward. It pays 10% of the employment tax liability that would have been due on their compensation for the most recent tax year, calculated at reduced rates, with no interest or penalties, and the IRS agrees not to audit the prior years' classification for those workers. The company files Form 8952 at least 120 days before the date it wants to start treating the workers as employees. VCSP doesn't resolve state taxes or wage and hour claims. Whether to use it, or simply convert going forward, is a question for your tax advisor.

How do I end the contractor agreement cleanly?

Pick a specific end date, the day before employment starts, and put it in writing: a short letter or mutual termination that ends the contractor agreement on that date, confirms that the IP assignment and confidentiality terms survive, and asks for a final invoice covering work through that date only. After the start date, the person stops invoicing and is paid only through payroll. Paying the same person on a 1099 and a W-2 for the same weeks invites questions about which relationship governed the work. Close out any contractor-provided tools, accounts or subcontractors, and make sure any open purchase orders or statements of work are completed or cancelled. See Startup Contractor Agreement.

How do I talk about pay?

Contractors often expect their contractor rate to become their salary. It doesn't work that way, because the company's cost of an employee includes the employer's share of Social Security and Medicare taxes, unemployment taxes and benefits, none of which it paid for the contractor. On the other side, the contractor was paying both halves of Social Security and Medicare through self-employment tax and buying their own health insurance. A lower salary plus benefits can leave the person in a similar position, but how it nets out for them is a question for their tax advisor. Show the math openly rather than presenting a lower number without explanation.

Example. A contractor bills $150,000 a year, and the company wants to keep its total cost at $150,000. Assume employer-paid benefits of $10,000 a year and $500 of unemployment taxes, an illustrative combined figure: federal unemployment tax is generally $42 per employee after the state credit, and state unemployment insurance varies by state and rate. The employer's share of Social Security and Medicare is 7.65% of salary at this level, so the salary that fits the budget solves salary × 1.0765 = $150,000 minus $10,000 minus $500 = $139,500, which is about $129,600.

The person gets a $129,600 salary, $10,000 of benefits they no longer buy themselves, an employer that pays half their Social Security and Medicare tax, and an ISO grant. Many companies also decide to pay more than the cost-neutral number to keep a valued person whole. Either way, the mechanics are the same, and the figures here are illustrative; your payroll provider can price the actual taxes and benefits in your state.

For more, see Should My Startup Hire Someone as an Employee or a Contractor?, Startup Contractor Agreement, The CIIA Agreement and NSO vs ISO.

If you're converting a contractor and want to confirm the IP and equity are clean first, contact us.