Why It Matters More Than You Think

Businesses love flexibility. But when it comes to hiring independent contractors, that freedom comes with fine print. Misclassifying employees as contractors is one of the most common (and costly) compliance mistakes we see. It can trigger IRS audits, DOL investigations, unpaid taxes, and even lawsuits. And no, having a signed contractor agreement won’t automatically protect you.
This issue falls under the Fair Labor Standards Act (FLSA), enforced by the U.S. Department of Labor (DOL). The IRS also plays a role in determining proper classification for tax purposes. Missteps can lead to major financial penalties and liability. At its core, it’s about control and independence. Just because someone works part-time, off-site, or by project doesn’t make them a contractor.

Proper Classification

According to the FLSA and IRS guidelines, three main factors determine proper classification:

1. Behavioral Control

Do you direct how, when, or where the work is done? Employees follow instructions. Contractors use their own methods.

2. Financial Control

Do you supply the tools? Control pricing? Restrict them from working with others? That’s likely too much oversight for a true contractor.

3. Type of Relationship

Are they a long-term, integral part of your team? Do you offer benefits or expect exclusivity? Those are employee characteristics.
The DOL’s final rule, effective March 11, 2024, reaffirms an “economic reality test” to determine whether a worker is truly in business for themselves or economically dependent on the employer—making them an employee under the FLSA.
Misclassification can lead to:
  • Back pay for wages, overtime, and benefits
  • Unpaid employment taxes, Social Security, and Medicare contributions
  • Civil penalties, interest, and legal fees
  • Class action lawsuits or audit findings
  • Reputational damage with current and future employees

Misclassification

Misclassification isn’t always intentional, but it is always risky. The good news? A few proactive steps can keep your business protected, your team structure clear, and your compliance on solid ground. Here’s what we recommend:

1. Audit your current team.

Start by reviewing all individuals paid via 1099 or labeled as contractors in the past 12 months. Look beyond titles and focus on how the work is structured. Do these individuals work exclusively for you? Use your equipment? Follow your processes or schedule? If the answer is yes, you may be crossing into employee territory under the FLSA’s new economic reality test. This applies even if the arrangement feels casual or temporary.

2. Document your classification decisions.

For every contractor or employee, keep clear documentation of how you made the determination. Save copies of contracts, job scopes, communication expectations, and any tools or resources you provide. If you’ve used IRS or DOL criteria to make the call, keep that analysis on file. This paper trail is critical in the event of an audit or legal dispute.

3. Reach out if you’re unsure.

If you’re questioning a role – or just want peace of mind – we’re here to help. At Abacus!, we work with business owners to proactively review worker classifications before they become costly compliance issues. We’ll walk you through the FLSA and IRS guidelines, flag any risk areas, and help you clean up the gray zones.
Getting classification right isn’t just about legal protection—it’s about building trust, setting clear expectations, and protecting the future of your business.