Too many small business owners think calling someone a subcontractor instead of an employee will save them time and money. It might feel easier now, but when the IRS or your state steps in, that shortcut can destroy your business. The difference between an employee and a subcontractor determines your taxes, your liability, and your protection. Here’s how to make the right call and what it’ll cost you if you don’t.
The Real Difference Between an Employee and a Subcontractor
The IRS defines an employee as someone whose work you control—what they do, how they do it, and when. You decide the hours, the tools, and the process. A subcontractor, on the other hand, controls their own schedule, uses their own equipment, and works with multiple clients.
To figure out where your worker falls, the IRS and most courts use what’s known as the Common Law Test, a three-part analysis that looks at behavioral control, financial control, and the overall relationship between you and the worker:
1. Behavioral control: Do you direct how the work is done?
2. Financial control: Do you pay hourly or reimburse expenses like you would for an employee?
3. Relationship type: Do you have a written agreement, and does the worker see themselves as independent or on your team?
If it looks like an employee, acts like an employee, and is paid like an employee, it’s an employee. Period.
States are Cracking Down
Several states have made it even harder to call someone a subcontractor. California’s AB-5 law set the tone, and others followed. Under that “ABC Test,” a worker is a subcontractor only if:
A. They’re free from control or direction in how the work is done.
B. Their work is outside your normal line of business.
C. They’re running their own independent business doing the same kind of work.
If all three aren’t met, congratulations—you’ve got an employee. That means payroll taxes, workers’ comp, unemployment insurance, and the works.
It might feel like more cost and paperwork, but it’s far cheaper than what happens if you ignore the rules.
The 7 Hidden Dangers of Misclassifying Workers
You can’t just hand someone a 1099 and call it good. When the IRS or state decides your “subcontractor” was actually an employee, the fallout hits fast. Here are seven ways that decision can wreck your business.
1. No Workers’ Comp Protection
If your worker gets hurt on the job and you never carried workers’ compensation, that’s on you. You can be sued personally, and your corporate veil can be pierced because you failed to manage your business properly. One injury claim can cost more than years of payroll taxes ever would.
2. Unemployment Claims
Fire a “subcontractor,” and they might file for unemployment. When the state can’t find your business in the system, guess who they audit next? You. Back premiums for unpaid unemployment insurance add up fast, especially if the worker wasn’t your first.
3. Overtime and Wage Claims
If your so-called subcontractor works more than 40 hours a week and decides you owe them overtime, they can make a claim. And win. Employment attorneys love these cases because they can recover triple damages and legal fees. That’s not a fight you want to be in.
4. Retirement Plan Discrimination
If you’ve been funding your 401(k) or SEP while misclassifying workers, you’ve just violated ERISA rules. The Department of Labor can require catch-up contributions for your workers, with penalties and interest that can cripple your business.
5. IRS Payroll Audits
Once the state flags you, the IRS joins the party. They’ll want back taxes, penalties, and interest for FICA and FUTA that were never withheld. Suddenly that “cheap” subcontractor decision costs you tens of thousands.
6. Partnership and Profit-Sharing Claims
Without a clear employment or subcontractor agreement, your worker could claim they were actually your partner. If you gave them “bonuses” or shared profits, that argument gets stronger. I’ve seen businesses destroyed by partnership disputes that started with one poorly defined relationship.
7. Third-Party Injury Lawsuits
Imagine sending your worker on an errand and they cause an accident. When the lawsuit hits, the injured party’s attorney will go after you, not the broke subcontractor. They’ll argue the worker was acting on your behalf, and your insurance might not cover it.
How to Protect Your Business
The fix is simple, but critical. If someone acts like an employee, classify them as one. Set up payroll, withhold taxes, and follow the rules. It’s not as painful as you think, and it protects you from far bigger headaches down the road.
When in doubt, talk to your CPA or a business attorney before hiring anyone in that gray area. The IRS even offers Form SS-8 to officially determine a worker’s status if you’re not sure.
Over anything else, document everything! Have written contracts for subcontractors, keep clean books, and make sure your business insurance covers everyone working under your roof.
The Bottom Line
Cutting corners on worker classification isn’t smart business. It’s an invitation for audits, lawsuits, and penalties that can wipe you out.
If you’re looking at your team right now wondering who counts as an employee or contractor, don’t guess. My team at KKOS Lawyers can help you get it right, protect your business, and avoid problems before they start. Book a call and we’ll review your setup, tighten your contracts, and make sure your payroll and structure are built to stand up under IRS or state scrutiny. Getting compliant now saves you far more later, and it’s one of the smartest moves you can make for long-term growth and peace of mind.
Play it safe. Classify correctly. Build a real team and protect yourself.
It’s even more entertaining when they try to dictate that the servant, er, “contractor” cannot market their services to other companies, despite having them on as a contractor and not an employee. They have no idea about how they “give away” their company secrets when they have so many contractors who are all miscategorized. INTELLECTUAL PROPERTY is priceless, and these business owners cannot understand that, but the bridges they burn by treating people badly puts their business in harm’s way.