I last wrote about this issue in August 2020. The law has changed and its time for an update.
Employee classification remains one of the most persistent and costly pitfalls for small and mid-sized businesses. It’s imperative that business owners properly classify their workers—not only for legal compliance, but also for the moral obligation of treating workers fairly. Misclassification can lead to enormous financial consequences, disrupt business operations and damage employee trust.
This guide walks through the key factors used to determine whether a worker is a W-2 employee or a 1099 independent contractor, and, if classified as an employee, whether they qualify as exempt or non-exempt under wage and hour laws.
W-2 Employee or 1099 Independent Contractor
Why It Matters
Both the IRS and the Department of Labor (DOL) closely review worker classification, but for different reasons:
- IRS / Tax Authorities: To ensure payroll taxes, unemployment taxes, and Social Security/Medicare contributions are properly collected.
- DOL / Labor Agencies: To ensure workers are not denied minimum wage, overtime, workers’ compensation, unemployment benefits, and other protections.
The Tests Used
Department of Labor’s Economic Reality Test. Key considerations:
- Degree of control the business exerts over the worker
- Worker’s investment in tools, equipment, or facilities
- Opportunity for the worker to experience profit or loss
- Skill, initiative, and independent judgment involved
- Permanency and duration of the relationship
- Whether the work performed is integral to the business’s operations
IRS’s Common Law Test. Factors are grouped under three main categories:
- Behavioral Control. How much direction and training does the business provide?
- Financial Control. Who covers expenses? Is the worker free to offer services to others? How is payment structured?
- Relationship of the Parties. Is there a written contract? Are benefits provided? Is the work ongoing or project-based?
Key Point. A signed “independent contractor agreement” does not guarantee contractor status; actual working conditions control the classification.
Rule of Thumb
If a worker uses your business’s tools, follows your schedule and instructions, and performs tasks central to your business operations, they are likely an employee (W-2).
Exempt vs. Non-Exempt Employees
Once a worker is classified as an employee, the next step is determining whether they are exempt or non-exempt under the Fair Labor Standards Act.
The Three-Part Test for Exemption
- Salary Level Test
- Current federal minimum (2025): $684 per week ($35,568 annually).
- Some states require higher thresholds (e.g., California, New York).
- Salary Basis Test
- Employee must receive a fixed salary not tied to the number of hours worked.
- Duties Test
- Employee’s primary responsibilities must fall into one of the following categories:
- Executive: Manages the business, supervises at least two employees, and has input into hiring/firing decisions.
- Professional: Performs work requiring advanced knowledge, typically gained through specialized education (e.g., lawyers, doctors, teachers, accountants, engineers).
- Administrative: Performs office or non-manual work directly related to management or general operations, involving independent judgment on significant matters.
- Employee’s primary responsibilities must fall into one of the following categories:
Clerical and routine office staff typically do not qualify as exempt.
Penalties for Misclassification
The risks of misclassification are substantial:
- Back Pay. Liability for unpaid overtime, wages, and denied benefits.
- Taxes and Contributions. Responsibility for both employer and employee shares of payroll taxes, plus unemployment insurance premiums.
- Fines and Interest. Civil penalties from the IRS, DOL and potentially state agencies.
- Lawsuits. Exposure to class action litigation from workers.
- Reputation Damage. Negative publicity and reduced ability to attract talent.
Recent legal battles in the gig economy highlight how costly and disruptive worker misclassification can be, with settlements reaching into the tens or hundreds of millions of dollars.
Practical Takeaways for Business Owners
- Consult legal counsel if uncertain. Classifications are nuanced and evolving.
- Don’t assume industry practice equals compliance. What competitors do may not be lawful.
- Audit regularly. Roles evolve; independent contractors may become employees over time.
- Know your state laws. Some states use stricter standards (e.g., California’s ABC Test), which favor employee status unless very narrow conditions are met.
Final Word
Misclassifying workers isn’t just a paperwork mistake; it’s a legal and financial trap that can cripple a business. By understanding the tests, applying the correct standards, and getting professional guidance when in doubt, you can protect not only your business but also the rights and livelihood of your workers.
Quick Reference Checklist: Employee vs. Independent Contractor
Worker Classification Side-by-Side
| Category | W-2 Employee | 1099 Independent Contractor |
| Control | Employer directs when, where, and how work is done | Worker controls how and when work is done |
| Tools/Equipment | Uses employer’s resources and facilities | Provides own tools and equipment |
| Exclusivity | Generally works for one employer | Can provide services to multiple clients |
| Payment | Regular paycheck (hourly or salaried) | Paid per project or flat fee, irregular basis |
| Expenses | Employer covers expenses | Worker covers own business expenses |
| Benefits | Eligible for benefits (health insurance, PTO, etc.) | Not eligible for company benefits |
| Taxes | Employer withholds income & payroll taxes (W-2) | Worker responsible for all taxes (1099-NEC) |
| Longevity | Often continuous, open-ended relationship | Typically project-based or short-term |
| Integral to Business | Performs work that is central to business operations | Performs work that is supportive or specialized |
Exempt vs. Non-Exempt Employees
Determining Overtime Eligibility
| Category | Exempt | Non-Exempt |
| Salary Level | Must earn at least $684/week ($35,568 annually, federal) | May earn any amount |
| Salary Basis | Fixed salary; pay does not vary with hours worked | Paid hourly or salary subject to hourly deductions |
| Job Duties | Executive, professional or administrative work with discretion and judgment | Routine, clerical, manual or service work |
| Overtime Pay | Not eligible for overtime pay | Eligible for overtime (time-and-a-half) |
| Examples | Managers, lawyers, accountants, engineers and teachers | Clerks, customer service, technicians and retail staff |
Quick Takeaways for Business Owners
- If you control the work, own the tools, set the schedule, and the worker performs your core business functions, they are likely an employee.
- To classify an employee as exempt, the position must meet all three tests (salary level, salary basis and duties).
- When in doubt, assume employee status… and seek legal guidance before finalizing classification.