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Worker misclassification occurs when a company engages someone as an independent contractor — typically a 1099 worker — when that person legally qualifies as an employee under federal or state law. Because contractor and employee status carry very different legal obligations (payroll taxes, benefits, overtime, leave, and more), misclassification isn't just a paperwork error: it creates retroactive liability for every paycheck issued under the wrong classification. The IRS, Department of Labor, and every state labor authority can initiate audits and enforcement actions — often going back years.
The line between contractor and employee isn't always obvious, and it's drawn differently by different authorities. Most misclassification isn't intentional — it happens because:
The key principle across most tests: the classification that matters is how the work actually functions — not what the contract says.
There is no single universal test. Federal agencies and states each use their own criteria:
IRS Common Law Test
The IRS looks at behavioral control (does the company control how the work is done?), financial control (does the worker have other clients, invest in their own tools?), and the type of relationship (permanent vs. project-based, benefits provided?). No single factor is decisive — the IRS weighs the overall picture.
California ABC Test (AB5)
California's AB5 law presumes every worker is an employee unless the company can prove all three conditions:
Failing any one condition means the worker must be classified as an employee. AB5 applies to any worker performing services in California — regardless of where the company is headquartered.
Other State Tests
New Jersey, Massachusetts, and Illinois use ABC tests similar to California's. New York and Washington apply their own multi-factor tests. This means a worker correctly classified as a contractor under federal rules may still be an employee under the state laws that apply to their location.
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Book a Demo When a misclassification claim is upheld, the exposure compounds across multiple categories:
For a single contractor earning $100,000/year over two years, total exposure can easily exceed what proper employment would have cost from the start — before any legal fees.
There's no way to fully eliminate risk without understanding how each jurisdiction classifies your workers. Practical steps include:
WorkGenius builds classification compliance into the platform itself. Before any engagement begins, every worker is assessed against the applicable state tests — including California's AB5 ABC test — automatically. If a worker's situation requires W-2 employment rather than contractor status, WorkGenius can act as the Employer of Record, taking on the legal employer role and eliminating the client's misclassification exposure from day one.
For companies hiring contingent workers across multiple states, this means a single platform handles the patchwork of state classification rules — rather than requiring you to maintain expertise in every jurisdiction where you hire.
No. The IRS, Department of Labor, and state labor agencies all run proactive audits — they don't need a worker complaint to investigate. The IRS's SS-8 process allows anyone to request a determination of worker status, but audits can also be triggered by payroll tax discrepancies, unemployment claims filed by workers you classified as contractors, or random selection. Retroactive liability accrues from the start of the misclassified relationship, not from the date of complaint.
No. Contract labels are a starting point, but regulators look at the substance of the relationship — not what the agreement says. A contract calling someone an independent contractor doesn't override the legal tests if the working relationship functions like employment. Courts and agencies routinely disregard contractor labels when the facts point to an employment relationship.
Yes. If a worker performs services in California — including remotely from California — AB5 applies regardless of where your company is incorporated or headquartered. This catches many out-of-state companies off guard. Any company with California-based contractors should assess those relationships against the ABC test.
These are distinct risks. Misclassification means treating an employee as a contractor when the law says otherwise — the primary risk is tax liability, penalties, and retroactive benefits. Co-employment refers to the risk of a client company being deemed a joint employer alongside a staffing agency or EOR — usually triggering liability for employment law compliance the client assumed the agency was handling. Both risks can be addressed by using a properly structured Employer of Record arrangement.
Updating a contract can help for future work, but it doesn't eliminate retroactive liability for the period the worker was already misclassified. If a relationship needs to be corrected, the right approach is formal reclassification — converting the worker to W-2 employee status, either directly or through an Employer of Record — and addressing any back-pay obligations. A new contract with the same working arrangement is unlikely to withstand scrutiny.
Explore more concepts in our workforce glossary
A third-party organization that legally employs workers on your behalf, handling all payroll, taxes, benefits, and compliance while you direct the work.
Learn moreEnsuring all worker engagements meet legal, regulatory, and policy requirements across classification, contracts, taxes, and labor laws.
Learn moreAny worker engaged outside of traditional permanent employment, including contractors, freelancers, temps, and gig workers.
Learn moreA formal document that defines the scope, deliverables, timeline, and payment terms for a project-based engagement with a contractor or freelancer.
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