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W-2 or 1099: How Worker Classification Actually Gets Decided

What the contract calls the relationship does not determine the classification. The nature of the relationship does — and it is assessed by several different authorities using several different tests, at least one of which is currently being rewritten.

For a related Monitask resource on employee time clocks, see this guide.

This is general information, not legal advice. Classification is fact-specific and consequential; take advice from employment counsel in the relevant states.

Why there is no single answer

At least four separate tests can apply to the same worker:

  • The DOL's economic reality test, for federal wage and hour law
  • The IRS test, for tax purposes
  • State tests, which in several states are considerably stricter
  • NLRB and state unemployment agency standards, applied in their own contexts

A worker can be an independent contractor for one purpose and an employee for another. This is not a loophole; it is the practical reality employers have to plan around.

The federal position, and why it is unsettled

The federal test has changed direction twice in recent years and is mid-change again.

A 2024 rule took a totality-of-the-circumstances approach with six factors and no predetermined weighting. In 2025 the DOL issued Field Assistance Bulletin 2025-1 instructing investigators to stop applying it, reverting enforcement to the earlier economic realities test.

Then on February 26, 2026, the DOL announced a Notice of Proposed Rulemaking on employee and independent contractor status under the FLSA, FMLA and MSPA, with the comment period closing on April 28, 2026.

The proposed rule would largely reinstate the test adopted in 2021 and rescind the 2024 rule. It re-establishes a five-factor economic realities test, giving greater weight to two "core" factors: the nature and degree of control over the work, and the worker's opportunity for profit or loss based on initiative or investment. The remaining factors are treated as additional guideposts that are "less probative" and very unlikely to outweigh the core factors where both point the same way.

What this means practically. Federal enforcement has been operating under the older, more flexible standard since 2025. The proposed rule would formalise that. But a proposed rule is not a final one, and this area has reversed with each administration — so build your arrangements to survive the stricter reading rather than optimising for the current one.

The IRS test is separate

The IRS applies its own analysis, grouped into three categories:

Behavioural control. Does the business direct or control how the work is done — instructions on when, where, what tools, what sequence, and training on procedures?

Financial control. Does the worker have unreimbursed expenses, a significant investment, the ability to seek other clients, opportunity for profit or loss, and payment by the job rather than by time?

Relationship. Written contracts, employee-type benefits, expected permanence, and whether the services are a key aspect of the business.

Nothing here is decisive on its own. The IRS weighs the whole picture — and a business can request a determination on Form SS-8 if a relationship is genuinely unclear.

States are stricter, and diverging

Worker classification is increasingly state-driven, and 2026 is a year of divergence. California remains the strictest through the ABC test under AB 5, with Massachusetts and New Jersey also maintaining tighter standards.

Under an ABC test, a worker is presumed to be an employee unless the hiring entity establishes all three of:

  • A — the worker is free from control and direction in performing the work, both under the contract and in fact
  • B — the work is outside the usual course of the hiring entity's business
  • C — the worker is customarily engaged in an independently established trade or occupation of the same nature

Prong B is the one that catches people. A software company engaging a software developer as a contractor fails it almost automatically, because the work is squarely within the usual course of the business — however genuinely independent the developer is.

California's AB 1514, effective January 1, 2026, refines the ABC-test exemptions for certain professionals, so the list of carve-outs is itself a moving target.

The federal enforcement pause offers short-term flexibility, but state enforcement continues, and audits have not stopped.

What misclassification costs

Federal. Back taxes — the employer's share of Social Security and Medicare, plus amounts that should have been withheld. Penalties and interest. Unpaid overtime and minimum wage under the FLSA, with liquidated damages.

State. Unpaid unemployment insurance contributions, workers' compensation premiums, state tax liabilities, and penalties that in some states are substantial.

Benefits. Claims for retirement plan participation, health coverage, and leave entitlements the worker should have had.

Private claims. Misclassification cases are frequently brought collectively, which is what turns a modest per-worker figure into a serious one.

Agencies also share information. A single unemployment claim from one contractor can trigger a broader audit.

Signals that a "contractor" is really an employee

  • You set their hours or require presence during set times
  • You direct how the work is done, not only what the outcome should be
  • They use your equipment and systems
  • They work only for you, or overwhelmingly for you
  • The relationship has run for years with no defined end
  • They do the same work as your employees
  • You train them in your procedures
  • You reimburse expenses in the way you would for staff
  • They have no ability to profit or lose based on their own decisions
  • Their work is central to your core business

Any one of these is survivable. Several together is a classification problem.

Practical guidance

Do not use a contract to fix a substance problem. A well-drafted agreement helps evidence a genuine relationship; it does not create one.

Design for the strictest applicable test. If you employ in California, Massachusetts or New Jersey, the ABC test is your planning baseline.

Keep documentation of independence. Their business registration, insurance, other clients, invoices, their own equipment.

Do not convert an employee into a contractor for the same work. This is the single most audited pattern.

Review long engagements annually. Relationships drift toward employment over time without anyone deciding to change them.

Use a staffing supplier where the relationship is genuinely employment-like but you do not want the headcount. The worker is properly employed as a W-2 employee of the supplier, which resolves the classification question rather than disguising it. That is how our contract staffing works.

The short version

Control and independence decide it, not paperwork. The federal test is being rewritten and has moved with each administration, so plan against the strictest test that applies to you — which for many employers is a state one, not a federal one.

PJP places contract workers as W-2 employees of ours, with the classification handled properly. Contract staffing → For broader reference, consult IRS worker-classification guidance.