The Contractor Who Isn’t
What you call someone doesn’t determine what they are — and the government doesn’t care about your paperwork
There’s an arrangement that shows up constantly in small business. One that feels completely normal, maybe even smart, until the day it doesn’t.
You bring someone on to do work. You call them a contractor. You send them a 1099 at the end of the year. You don’t withhold taxes, don’t pay benefits, don’t run them through HR. Clean. Flexible. Off the payroll.
Except the IRS, your state tax authority, the Department of Labor, and potentially a plaintiff’s attorney are all looking at the same arrangement — and they may not agree with your characterization.
That’s the contractor misclassification time bomb. For a lot of small and family businesses, it’s been sitting on the desk for years.
The Label Doesn’t Do the Work
Here’s the thing most business owners don’t fully internalize: calling someone a contractor doesn’t make them one.
The legal test — at the federal level and in virtually every state — is based on the actual nature of the working relationship, not what your agreement says, not what the 1099 says, not what both parties agreed to call it.
The core question, simplified: does your business control not just what work gets done, but how it gets done?
If you set the hours, direct the methods, require the person to use your tools, prohibit them from working for others, or treat them as an integrated part of your operation — those facts push toward employee, regardless of the label. It doesn’t matter if they signed an independent contractor agreement. It doesn’t matter if they wanted the 1099 arrangement. What matters is the economic reality of the relationship.
And that reality has a way of surfacing at the worst possible moments: an audit, a workers’ comp claim, an unemployment filing, a lawsuit.
The Multi-State Problem Nobody Talks About
The federal test is already complicated. Then you layer in the states, and it gets worse.
California uses something called the ABC test — one of the strictest frameworks in the country. Under it, a worker is presumed to be an employee unless you can demonstrate, among other things, that the work they perform is outside your usual course of business. That last requirement alone disqualifies arrangements that would hold up fine everywhere else.
Other states have adopted similar frameworks. The result: a contractor classification that’s defensible in Texas may be indefensible in California. And if that contractor lives in California, works remotely, and performs services that benefit your business, you may have a California problem even if your company has never set foot there.
This is the multi-state creep. You hired one remote contractor for a project. They’re in a state with aggressive classification rules. Now you have potential payroll tax liability, benefits exposure, and a workers’ comp question in a jurisdiction you weren’t thinking about. Multiply that by three contractors in three states and the exposure multiplies with it.
What’s Actually at Stake
When a contractor is reclassified as an employee — by an audit, a claim, or a court — the exposure typically includes:
Back payroll taxes. The employer’s share of Social Security and Medicare that should have been withheld and remitted, often going back two to three years.
Interest and penalties. These accrue from the date the taxes should have been paid. They don’t negotiate themselves away.
Benefits claims. If your company provides health insurance, retirement contributions, or paid leave to employees, a reclassified worker may have a claim for the value of those benefits for the period they were misclassified.
Overtime. Contractors aren’t subject to FLSA overtime rules. Employees are. A reclassified worker who regularly worked more than forty hours a week may have a wage claim that goes back years.
Workers’ comp. If an uninsured contractor is injured and gets reclassified, the liability exposure can be significant — and your general liability policy may not cover it.
None of this requires bad intent. You can genuinely believe someone is a contractor, document it reasonably, act in good faith, and still face all of the above. The test is objective, not based on what you thought you were doing.
The time bomb doesn’t care about your intentions. It just cares about the facts.
The Honest Assessment
Not every contractor relationship is a problem. If you hire a graphic designer to build a website, pay them a flat fee, they set their own hours, use their own tools, and work for multiple clients — that arrangement should hold up fine.
The ones that create risk look like employment in practice: a fixed weekly schedule, ongoing work without a defined project end, direction about how the work gets done, integration into your team’s daily operations, economic dependence on your business as a primary income source.
Go through your contractor roster with that lens. If someone has been with you for three years, works for you exclusively, logs into your systems every day, and takes direction from your managers — that arrangement deserves a harder look. The question isn’t whether you’ve been doing something wrong. The question is whether the structure still matches the reality.
What You Can Actually Do
Audit your arrangements. Pull your 1099s from the last two or three years. For anyone with a significant or ongoing relationship, ask: would this hold up under the economic reality test? Under your state’s version of it?
Check where your contractors live. If they work remotely, know which states they’re in. California, Massachusetts, and New Jersey apply stringent standards. If you have contractors there, understand what that means.
Consider reclassification proactively. If an arrangement looks like employment, converting the person to employee status — even if they prefer the contractor arrangement — is almost always cheaper than defending a reclassification after the fact.
Look at your agreements. A well-drafted contractor agreement doesn’t fix a misclassified relationship, but it documents intent and reflects the factors that support contractor status. If yours is a one-page form you downloaded a decade ago, it’s worth updating.
The pattern here is the same one we talked about the last couple of weeks. Not an obvious failure. A quiet accumulation of exposure from an arrangement that looked fine on the surface — until someone looked harder.
The good news: this one is fixable, often without drama, if you catch it before someone else does.
Mike Lang is a transactional lawyer who writes weekly for founders and family business owners navigating the deals that define their companies. Questions or topics you want covered? Reply to this email.