Contractor or employee

Here is the mistake I most want this module to prevent. You find someone good. You say, let's keep it simple, I'll just pay you as a contractor. Nothing is simpler, everyone does it, and if the relationship ever ends badly, the paperwork you signed matters less than the relationship you actually ran.

Contractor versus employee is not a preference menu and it is not a cost decision. It is a classification question. The facts of the working relationship decide it, agencies and courts grade it after the fact, and no label, contract, or payment method changes the answer. Both the IRS and the Labor Department say this in almost the same words: calling someone an independent contractor, paying them off the books, handing them a 1099, or having them sign a contractor agreement does not make them one.

What the IRS asks

The IRS applies common-law rules about control, and says to weigh all evidence in three categories. There is no magic number of factors and no scorecard; the whole relationship decides.

Behavioral control. Do you control what the worker does and how they do it? Training, instructions on sequence and method, a required process, a set schedule. If you train someone and direct their methods, that points to employee.

Financial control. How are they paid, who provides tools and supplies, is their expense reimbursed, can they profit or lose money on the job, do they market to other clients? A person with their own equipment, their own rates, their own customers, and a chance to lose money on a bad day points to contractor.

Relationship type. Written contracts, benefits, permanence, and whether the work is a key aspect of your business. Ongoing, indefinite, core-service work points to employee. Project-based, peripheral work points to contractor.

If you are genuinely stuck, the IRS will rule for you: Form SS-8 asks the IRS to determine a worker's status. Either side can file. The catch is patience, since the IRS itself says a determination can take at least six months.

What the Labor Department asks

The Fair Labor Standards Act side uses an economic reality test, currently six factors from the 2024 rule: opportunity for profit or loss depending on managerial skill, investments by both sides, permanence of the relationship, nature and degree of control, whether the work is integral to your business, and the worker's skill and initiative. No single factor decides; the totality does, and the goal is one question: is the worker economically dependent on your business, or in business for themselves?

You should also know the ground is moving. The 2024 rule's status is in litigation, and in February 2026 the Labor Department proposed replacing it through a new rulemaking, with the public comment window closed in late April 2026. I am not going to pretend the federal test is settled when it visibly is not. That is exactly why the practical rule below leans conservative, and why you check the current federal and your state's rules in the same week you hire.

Your state can be stricter

Several states apply ABC tests, where all three prongs must pass: the worker is free from your control, the work is outside your usual business, and the worker has an independently established trade. The B prong is the killer for a small business: hiring a contractor to do the very thing your company sells fails it, full stop, in those states. Your state labor department's worker classification page states which test applies where you live. Ten minutes of reading before the offer.

The tax paperwork either way

For employees you withhold from day one: W-4 at hire, W-2 at year end, deposits and quarterly returns through your payroll app.

For contractors the reporting bar moved: for payments made in 2026 and after, you file a Form 1099-NEC when you pay a person or unincorporated business two thousand dollars or more in the year, up from six hundred. The 2025 law raised that threshold itself and indexes it with inflation after 2026; the IRS proposed regulations now circulating carry the mechanics. For 2025 payments the old six hundred threshold still applies. Get a W-9 from every contractor before their first payment so you have the legal name and taxpayer ID on file, whatever the year's total turns out to be.

Defaults that keep you out of trouble

After reading every classification guide, agency page, and operator war story this module is built on, here is the conservative pattern I would follow for a first hire.

The recurring core of your delivery, done to your standard, on your schedule, with your training and tools: make it a W-2 employee. Part-time is fine. This is what a first hire usually is, and pretending otherwise is where audits come from.

A defined project or specialty a professional already runs as their own business, with their own tools and methods, other clients, and their own rate: contractor, and make the paperwork match the reality. A bookkeeper, a photographer for a reshoot, a designer rebuilding your site.

You want the employee relationship without becoming an HR department in week one: a staffing agency or employer-of-record employs the person and you pay the agency. Food-production operators in the corpus used exactly this to stay compliant while tiny. It costs a premium on the wage and it is often worth it.

And the dead zone to refuse: someone who works only for you, on your schedule, with your tools, in your core service, priced hourly, indefinitely. That person is an employee no matter what the invoice says. Hire them as one.

None of this is legal advice, and state law varies enough that a thirty-minute consult with an employment attorney before your first W-2 is among the best money this module will ever tell you to spend. The setup layer of entity, licenses, and insurance has its own treatment in this series; what belongs here is only the classification call itself.

One more distinction while we are being honest with ourselves. A contractor is a vendor you direct by result. An employee is a person you direct by method. The next thing to decide is what result you are actually buying, because if you cannot state it, neither arrangement will save you.