Hiring your first contractor: the classification mistake that gets agencies sued

Why the contractor label is not yours to assign

Classification is a legal determination, not a business decision. You cannot make someone an independent contractor just by calling them one in an agreement or on an invoice. The classification is determined by the ground-level facts  of the working relationship, regardless of what the contract says. A worker who is functionally an employee is legally an employee, and the consequences for misclassification run backward, often reaching back two or four years, depending on the claim and the state. 

Multiple tests apply simultaneously. Federal agencies use different tests than state agencies, and they can reach different conclusions about the same worker. The IRS test built on three categories: behavioral control, financial control, and the type of relationship. The Department of Labor applies an economic reality test. California applies the “ABC” test, which is among the strictest in the country. If you operate across state lines or have remote workers, you may be subject to multiple frameworks at once.

The behavioral control factors that sink most businesses

Supervision and direction. If you tell a worker when to work, how to do the work, and which tools to use, those are indicators of an employment relationship. An independent contractor is hired for a result, not a process. The more you direct the how and when, the harder the contractor classification is to defend.

Exclusivity and schedule requirements. Requiring a worker to work set hours, to be available exclusively to your business during a project, or to attend regular internal meetings weakens contractor status. True independent contractors set their own schedules and typically serve multiple clients.

Training. If you provide training on how to perform work, that is an indicator of employment. Independent contractors are hired because they already have the skill. Onboarding a new hire into your process and workflow reads as an employment relationship.

The financial control factors

Fixed salary versus project-based pay. Paying a worker a fixed monthly or weekly amount, regardless of deliverables completed, looks like a salary. Independent contractors are typically paid per project or per deliverable, bear the risk of completing the work, and have the opportunity to profit or lose based on how efficiently they work.

Expense reimbursement. If you reimburse a worker for business expenses, such as software subscriptions, equipment, or travel, that is an indicator of employment. Independent contractors typically cover their own operating costs as part of running their own business.

Integration into the business. If the worker's services are central to what your business sells, rather than an ancillary or specialized function, regulators are more likely to see an employee. Businesses treating core production staff as contractors face the highest misclassification risk.

What your contractor agreement actually needs to say

Scope defined by deliverable, not role. The agreement should define what the contractor will produce, not what role they will fill. 'Deliver ten edited videos per month' is a contractor scope. 'Serve as our video editor' describes a position. The distinction matters when a labor agency reviews the relationship.

Right to subcontract. A contractor agreement should give the worker the right to subcontract or delegate their work to someone else. The ability to delegate is a hallmark of running an independent business. If your agreement prohibits subcontracting and requires personal performance, that factor cuts against contractor status—though it is one factor among many, not a dealbreaker on its own.

Termination provisions. At-will termination clauses, where either party can end the relationship at any time for any reason, look more like employment than a business-t0-business engagement. A stronger contractor agreement ties termination to deliverable failure or material breach, not simply to convenience.

California's ABC test: the highest bar

If any of your contractors are based in California, or if you are a California agency, the ABC test is the presumptive standard, it starts with a presumption of employment. To prove contractor status, you must show all three: the worker is free from your control, the work is outside your usual business, and the worker is engaged in an independently established trade. Most businesses fail the second prong because the contractor is doing exactly what the business sells to clients. California does carve out exemptions. Certain professional services — including graphic design, freelance writing, photography, and marketing — are analyzed under an older multi-factor test instead, but only if the worker meets strict conditions, like maintaining a separate business location and setting their own rates and hours. There is also an exemption for genuine business-to-business relationships. Do not assume an exemption applies. Whether your contractor qualifies is exactly the kind of fact-specific question that should go to a lawyer.

[Attorney review note: California ABC test application and any state-specific classification standards should be verified by Travis before publishing.]

How to use Inhouse

Start by describing the working relationship: how long the engagement has lasted, how the worker is paid, what level of direction you provide, and whether the worker has other clients. Inhouse can produce a contractor classification risk assessment based on the federal and state tests, a revised independent contractor agreement with provisions that better support contractor status, and a checklist of relationship changes to make before the next engagement begins.

What gets routed to a lawyer: any worker who has already raised a classification complaint, any situation involving a California-based worker, and any relationship that has lasted more than six months with exclusive or near-exclusive work.

"I run a business  in [state]. I have been working with a designer for [X months]. I pay them a fixed monthly rate and they work mostly for us. I want to understand if they should be classified as a contractor or an employee and what I need to change."

Bottom line

Misclassification is not a paperwork problem. It is a liability that compounds every month the relationship continues incorrectly. Businesses that catch it early and restructure the relationship or the agreement are in a far better position than those who get audited. Start with Inhouse to assess your current contractor relationships and get your agreements tightened, then have a licensed employment attorney review before your next contractor engagement starts.

Legal notes

This article is general legal information, not legal advice, and does not create an attorney-client relationship. Worker classification law varies significantly by state, and some states, particularly California, apply substantially stricter standards than federal law. The tests described here are illustrative summaries; the actual analysis is fact-specific and depends on the totality of the working relationship. Classification determinations can result in back tax liability, penalties, and civil claims by workers. Consult a licensed employment attorney before making classification decisions or restructuring existing contractor relationships.