Sense with Cents

One of the most expensive questions in small business payroll, and it usually gets asked after the fact.

Sooner or later, most small businesses ask whether a new worker can be paid as a contractor instead of an employee. The appeal is easy to see. No withholding, no payroll taxes, no workers’ comp, just a 1099 at year-end.

The question is fair. The trouble is that the business does not get to decide the answer by picking one. The law decides, and more than one law gets a vote.

My starting point: employee

My standard is simple. A worker is an employee unless the business can show otherwise under every rule that applies. Not one rule. Every rule.

That is not a legal opinion, and I am not a lawyer. It is the safest default I know of, and it matches how the agencies tend to look at it. A contract that says “independent contractor” at the top does not settle the matter. What the work actually looks like does.

Which rules?

Here is where it gets familiar to anyone who read When Wages Are Not Wages. “Employee” is another word that means different things depending on who is asking.

The IRS has its own test, built around control: who decides how, when, and where the work gets done, and who carries the financial risk. It used to be a list of 20 questions. The list was not bad, but 20 questions is more than most business owners will sit through. Today the IRS groups the same ideas into three categories: behavioral control, financial control, and the relationship itself. The Department of Labor has a different test for wage and overtime law, and it has been rewritten more than once in recent years. States have their own tests, often more than one per state, for income tax, unemployment, workers’ comp, and wage law.

A worker can pass one test and fail another. That is why “someone told me a 1099 is fine” is not the end of the conversation. It may be fine for one agency and wrong for the next one to ask.

The ABC test as a yardstick

California uses what is called the ABC test for most purposes. A worker is an employee unless the business can show all three of these:

• A. The worker is free from the business’s control in how the work is done.
• B. The work is outside the usual course of the business.
• C. The worker is regularly in an independent trade or business of that same kind.

Part B is where most arrangements fall apart. A bakery hiring a “contract” baker has a hard time arguing that baking is outside its usual business. (I owned a bakery once. I would not have tried.)

Some people treat the ABC test as a nationwide yardstick, reasoning that it is likely the strictest, so a worker who passes it should pass anywhere. I understand the logic, and it points in the right direction. It is not a legal safe harbor, though. Other states and agencies weigh different factors, so the rules where you actually operate still have the last word.

The questions I would ask

The tests use different words, but they circle the same practical questions. Before calling someone a contractor, these are the ones I would want clear answers to. Seven, not 20:

• Does the person have other customers, or do they work only for you?
• Do they have their own business license?
• Do they carry their own insurance?
• Do you set their hours?
• Do you pay them by the hour, rather than by the job?
• Can they send someone else to do the work?
• Do you decide how the work gets done (set hours or days), or only what the finished result should be (a deadline and the finished product requirements)?

No single answer settles it. But the more the answers sound like a job, the more likely every agency will call it one.

The cost of getting it wrong

When a contractor turns out to be an employee, the bill usually arrives years later, all at once. Back payroll taxes, often including the employee’s share the business never withheld. Unemployment and workers’ comp premiums. Unpaid overtime. Penalties and interest on all of it.

The worker can also sue. Federal wage law has long allowed that, and some states have added their own right to sue over misclassification, sometimes with the business paying the legal fees if it loses. California adds civil penalties for willful misclassification that run into the thousands of dollars per violation.

A 1099 saves a little money every payday. Getting it wrong can cost more than every one of those paydays combined. That math is why I start with employee.

Contractors do not belong in payroll

Once a worker truly is a contractor, a related question comes up: can we just pay them through payroll with the taxes turned off? The answer is no. The same goes for rent, vendors, and other bills.

Payroll is built for employees. Every check it writes lands in quarterly returns, W-2s, and wage reports. Running a contractor through it either withholds taxes that should not be withheld, or produces a pay record with the taxes zeroed out that looks like an employee nobody taxed. Neither helps you in an audit. It also undercuts the classification itself. Picture how that goes in front of a judge. “Your Honor, they are not an employee.” “Then why did you pay them with payroll software?”

Contractor payments belong on the bill-paying side of the books, with a 1099 at year-end. Keeping the two apart is one of those habits that costs nothing and saves an argument later.

The takeaway

Worker classification is a human call, not a software setting. Payroll software can pay an employee correctly. It cannot tell you whether the person should be an employee in the first place.

So my approach is to start with employee and make the contractor label earn its place, under every rule that applies where the work is done. When in doubt, ask an employment attorney before the first check, not after the first audit letter.