October 13, 2026
An employee works under the company’s control: you decide when, where and how the work gets done. An independent contractor runs their own business and delivers a result. The IRS, the Department of Labor and each state use different tests, but they all look at how the relationship works in practice, not at what the contract calls it, and some states presume that every worker is an employee.
Key takeaways
More than one, and they don’t always agree. The test depends on which law is at issue and where the worker lives and works, not where the company is incorporated.
| Who applies it | Test | What it looks at |
|---|---|---|
| IRS (federal payroll taxes) | Common-law control test | Behavioral control (how the work is done), financial control (who pays expenses, provides tools and can profit or lose), and the relationship (benefits, permanence, written contract) |
| Department of Labor (federal minimum wage and overtime) | Economic reality test | Whether the worker is economically dependent on your company or is in business for themselves |
| States such as California, Massachusetts and New Jersey | ABC test | The worker is an employee unless (A) they’re free from your control, (B) the work is outside the usual course of your business, and (C) they’re independently established in that trade |
Other states use one of these tests for some purposes and a different one for others, such as unemployment insurance or wage claims. For a remote worker, the law of the state where they work applies.
It has changed several times. A Department of Labor rule that took effect in March 2024 weighed six factors equally. In May 2025, the Department said it would stop applying that rule in its own investigations, and in February 2026 it proposed replacing it with a test that gives the most weight to two factors: the worker’s control over the work and their opportunity for profit or loss. Check the current federal rule before relying on it. For most startups, the stricter state tests decide the question anyway.
Ask yourself a few questions. Do you set their hours, or do they? Do they use your laptop and systems or their own? Do they have other clients? Are they paid by the project or by the hour, week or month? Could they hire someone else to do the work? Is the work something your company does for its customers, or something outside your core business? Is the relationship open-ended?
The more the answers point to your control, your equipment, a single client and ongoing core work, the more likely the person is an employee. A practical test: if you’d be upset if they didn’t show up on Monday, they’re probably an employee. A designer who refreshes your logo on their own schedule is a contractor. An engineer who works full time on your product, attends your standups and has no other clients is an employee, whatever the contract says.
Usually not. A co-founder who works full time under the company’s direction is an employee if they’re paid. Paying them on a 1099 to avoid payroll is a classic misclassification, and investors will flag it in diligence. A founder who isn’t taking a salary doesn’t need to be on payroll, but the zero salary should be documented in writing. The narrow exception is a part-time technical co-founder who keeps an independent consulting practice, and even then the arrangement should be documented. See Startup Founder Salary.
Both are non-employees. An advisor gives occasional guidance, usually for equity, under an advisor agreement. A contractor delivers defined work product, usually for cash and sometimes for equity, under a contractor agreement with a scope of work. Someone building your product isn’t an advisor. They’re a contractor or an employee. See Startup Advisor Agreement.
The contractor, unless the agreement assigns it to the company. An employee’s work made within the scope of the job generally belongs to the employer, but a contractor’s work doesn’t, even if you paid for it. Every contractor agreement needs present assignment language (“hereby assigns”), signed before work starts. If you later convert the contractor to an employee, have the CIIAA cover everything they created before the switch. See Who Owns Startup IP? and Startup Contractor Agreement.
US tests don’t decide it. The law of the country where the person works does, and many countries have their own misclassification rules and penalties. Use a contractor agreement written for that country, or an employer of record if the person is really working as a full-time employee.
The company can owe the payroll taxes it should have withheld and paid, with interest and penalties; unpaid minimum wage and overtime, often doubled as damages, plus the worker’s legal fees; unemployment insurance and workers’ compensation premiums; and, in some states, civil penalties for each violation. Look-back periods run from two to six years depending on the claim and the state. Misclassification also shows up in diligence, where investors and buyers may require you to fix it before closing.
Contractors also aren’t outside employment law entirely. In some states, including New York and California, anti-discrimination laws cover contractors, and several states’ non-compete bans cover them too.
Convert the worker to an employee going forward with a new offer letter and CIIAA, and run them through payroll from that date. For past periods, the IRS offers a Voluntary Classification Settlement Program that can reduce the federal payroll tax owed. Wage and state exposure is separate, so talk to your lawyer and a tax advisor before you act. Keep the IP chain intact by making sure the new CIIAA assigns everything created during the contractor period.
For more, see Should My Startup Hire Someone as an Employee or a Contractor?, Can Startup Workers Be Paid Only in Equity? and What Should Founders Know About Startup Employment Law? If you’d like help classifying a worker or papering the relationship, see our Independent Contractor Agreement and Employment Agreement services or contact us.
