Employee Classification Compliance: W-2 vs. 1099

Employers must regularly ask whether they’re meeting their legal requirements — and one of the first questions is whether a worker is correctly classified as a W-2 employee or a 1099 independent contractor. This is a tricky minefield, because different states and government agencies use different tests.

California’s ABC Test

In California, the ABC test determines employment status. It defaults all workers to employees unless the hiring entity meets all of the following:

• The worker is free from the control and direction of the hiring entity in performing the work, both under the contract and in fact
• The worker performs work outside the usual course of the hiring entity’s business; and
• The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed

The IRS Factor Test

Other agencies, like the IRS, classify workers using a factor test examining behavioral control, financial control, and the relationship of the parties.

Behavioral Control

A worker is more likely an employee when the business has the right to direct and control the work — even if that right isn’t exercised. Factors include the type and degree of instructions given (when/where to work, what tools to use), evaluation systems measuring how work is done, and training the worker on procedures and methods (strong evidence of employee status, since contractors typically use their own methods).

Financial Control

Does the business control the financial aspects of the worker’s job? Consider significant investment in equipment, unreimbursed expenses (more common for contractors), opportunity for profit or loss (an indicator of a contractor), whether services are available to the market, and method of payment (employees are generally guaranteed a regular wage; contractors are most often paid a flat fee per job).

Relationship of the Parties

This depends on how the worker and business perceive their interaction, including: written contracts describing the intended relationship (though a label alone isn’t enough to determine status), employee-type benefits like insurance or pension/vacation/sick pay (which point to employee status), the permanency of the relationship (an indefinite relationship suggests employment), and whether the services are a key activity of the business.

The Bottom Line

When determining whether a worker is an employee or independent contractor, all the facts of the relationship must be considered — not just the label. Misclassification can lead to serious consequences, including penalties for unpaid wages and employment taxes. Classify carefully, and get help if you’re unsure — it’s far cheaper than a misclassification claim.

Frequently Asked Questions

How do I know if a worker is an employee or contractor?

It depends on the facts of the relationship, not the label. California uses the strict ABC test (defaulting workers to employees), while the IRS weighs behavioral control, financial control, and the relationship of the parties.

What is California's ABC test?

It defaults all workers to employees unless the hiring entity proves all three: the worker is free from control, performs work outside the company's usual business, and is independently engaged in that trade. Failing any prong means the worker is an employee.

What happens if I misclassify a worker?

Misclassification can lead to penalties for unpaid wages and employment taxes, among other consequences. Because tests vary by state and agency, a classification review is worthwhile — especially for multi-state employers.

This article is general information from Accord & Shield Legal, PLLC and is not legal advice. Reading it does not create an attorney-client relationship. For guidance on your specific situation, please consult a qualified attorney.