Classifying workers correctly is one of the most important—and most misunderstood—legal decisions early-stage companies make. Treating someone as an independent contractor when they should legally be an employee can create serious wage, tax, and compliance issues. These mistakes often surface at the worst possible time: during fundraising, diligence, or an acquisition.
The challenge is that there isn’t one single test for determining worker status. Different agencies and states apply different standards, and the rules have shifted in recent years. But the underlying principle hasn’t changed: labels don’t matter—the reality of the relationship does.
Here’s what founders need to know.
1. Why Misclassification Matters
When a contractor is legally an employee, companies may be liable for:
Unpaid minimum wage and overtime
Missed meal and rest break penalties (state-dependent)
Back taxes, payroll withholdings, and IRS penalties
Workers’ compensation and unemployment insurance contributions
Employee benefits obligations
Liability under discrimination, harassment, and leave laws
Civil fines and enforcement actions
Individual lawsuits or class actions
Reputational damage with investors, employees, and acquirers
Misclassification is rarely intentional, but the consequences are the same either way.
2. Job Titles Don’t Decide Status—Conduct Does
Founders often assume that if they:
Call someone a “contractor,”
Use a 1099 instead of a W-2, or
Sign an independent contractor agreement,
…then the relationship is a contractor relationship.
That’s not how the law works.
Courts and regulators look past the paper and examine what actually happens day-to-day. If the company directs and controls the work, sets schedules, integrates the person into operations, or relies on them like an employee, then legally they are an employee—regardless of what the contract says.
This principle applies at the federal level and in every state.
3. The Federal Standard: Economic Realities Test
Under the Fair Labor Standards Act (FLSA), the central question is:
Is the worker economically dependent on the company, or are they truly in business for themselves?
To answer this, regulators and courts consider multiple factors, including:
Degree of control
Who decides how, when, and where the work is done?
If the company sets schedules, requires meetings, or directs workflow, that leans toward employee status.
Opportunity for profit or loss
Can the worker meaningfully increase profit or incur loss based on managerial skill?
True contractors set their own rates, negotiate scope, and manage multiple clients.
Investment in equipment or tools
Contractors typically invest in their own tools, software, and resources.
If the company provides everything, that leans employee.
Permanence of the relationship
Ongoing, indefinite work resembles employment.
Short-term, project-based work leans contractor.
Integration into the business
If the work is central to the company’s core operations, regulators are more likely to see the worker as an employee.
Skill and independent initiative
Contractors typically market their services, set their own methods, and exercise independent judgment in how the work is performed.
No single factor controls. The test looks at the full relationship.
A Note on 2024–2025 Updates
The Department of Labor issued a contractor classification rule in 2024, but as of 2025 the agency is not applying that rule in enforcement and has reverted to the traditional economic realities framework. The 2024 rule still technically applies in private litigation, but the practical standard remains the multi-factor analysis above.
4. The IRS Has a Different Test
The IRS applies a common law control test for tax purposes, focusing on:
Behavioral control
Does the company dictate how work must be performed?
Financial control
Who controls invoicing, reimbursement, and investment in tools?
Relationship of the parties
Is there a written contract? Does the worker receive benefits? Is the work ongoing?
A worker might be classified as a contractor for tax purposes but an employee under FLSA—or vice versa. These systems don't always align.
5. State Laws Can Be Stricter Than Federal Law
Some states apply far tougher standards than the federal test.
For example, California, Massachusetts, and New Jersey use the ABC Test, which presumes a worker is an employee unless the company proves:
A. The worker is free from control and direction;
B. The work is outside the usual course of the company’s business;
C. The worker is independently established in that trade.
The toughest part is B: if the worker performs work that is part of what the company “normally does,” they are almost always an employee under ABC states.
Why this matters in 2025
Remote work means you inherit the laws of the state where the worker sits—not the state where your company is based. If your “contractor” works from California, California’s ABC Test applies.
This catches many startups by surprise.
6. Practical Patterns: When Contractors Are Really Employees
Even without running through every test, certain patterns strongly signal employment:
You set the worker’s hours
You require daily or weekly internal meetings
You give them a title that fits into your org chart
They use your equipment and internal tools
You expect long-term availability
You assign tasks rather than negotiate deliverables
They support essential business functions
You would be disrupted if the worker stopped working tomorrow
These patterns show economic dependence and integration—hallmarks of employment.
7. When Contractor Status Makes Sense
Contractors generally fit best in roles that are:
Project-based
Clearly scoped with deliverables
Short-term or intermittent
Not core to your daily operations
Performed by someone who works with multiple clients
Highly specialized, with the worker providing their own tools and methods
The cleaner the boundaries, the safer the classification.
8. What Founders Should Do Before Classifying Anyone
A few steps can dramatically reduce risk:
Review the actual working relationship
Not just the contract—what will day-to-day look like?
Check the worker’s state laws
Remote workers trigger local employment law.
Identify where the worker fits into your operations
Are they supplementing employees or replacing a role you’d otherwise hire?
Define scope, deliverables, and timelines clearly
Ambiguity invites misclassification.
Avoid giving contractors employee-like perks
Titles, benefits, equipment, and fixed schedules push them into employee territory.
When in doubt, classify as an employee
It’s almost always cheaper than getting it wrong.
9. The Bottom Line for Startups
Misclassification isn't just an HR or compliance issue—it’s a strategic risk. Investors, acquirers, and regulators scrutinize classification decisions, and errors often surface during diligence when they’re most costly to fix.
With federal rules evolving and many states applying more aggressive standards, classification is no longer something startups can treat casually. The safest path is to evaluate each worker thoughtfully and document your reasoning.
If you need help reviewing a contractor relationship, assessing state-law risks, or structuring roles properly, Rubicon can guide you through a clean, defensible approach.