Using Contractors to Reduce Payroll Costs

If you're a small business owner trying to decide how to classify a worker (as a 1099 independent contractor or a W-2 employee), you might find the legal landscape confusing. That’s because different government agencies use other tests to determine a worker’s classification. The two most influential are the ABC Test, often used by states, and the IRS Common Law Test, which governs federal tax obligations.

In this second article of our three-part series on worker classification, we explain what these tests are, how they differ, how to use contractors legally to manage payroll costs, and what you should know based on where your business operates.

Why Multiple Tests Exist

Worker classification affects more than just taxes. Different laws regulate different parts of the employment relationship:

• The IRS determines classification for federal tax purposes.
   
• The Department of Labor (DOL) oversees wage and hour laws (e.g., overtime, minimum wage).
   
• State laws govern unemployment insurance, workers’ compensation, and labor protections.

As a result, you may find that a worker is considered an independent contractor for one purpose and an employee for another, especially if you operate in a state that uses the ABC Test. Misunderstanding which rules apply can result in noncompliance, audits, and fines.

What Is the IRS Common Law Test?

The IRS Common Law Test focuses on the degree of control an employer has over the worker. It breaks the relationship down into three categories:

1. Behavioral Control

• Does the company control how the work is done (instructions, training, evaluation)?
• Example: If you train a worker, require specific hours, or supervise them closely, they’re more likely to be an employee.

2. Financial Control

• Does the worker have a significant investment in their tools?
• Can they realize a profit or loss?
• Are they paid by the job (contractor) or by the hour/salary (employee)?

3. Type of Relationship

• Are there written contracts?
• Are benefits like vacation and health insurance provided?
• Is the work permanent or temporary?
• Is the service provided a key aspect of your business?

The IRS weighs all these factors, with no single one being decisive. The more control a business has, the more likely the worker is an employee.

What Is the ABC Test?

The ABC Test is a stricter standard, and it assumes workers are employees unless all three of the following conditions are met:

1. The worker is free from the company’s control and direction in performing the work.
2. The work performed is outside the usual course of the company’s business.
3. The worker is engaged in an independently established trade, occupation, or business of the same nature.

Let’s break this down:

• Failing any one of these means the worker is considered an employee.
   
• Under this test, a freelance graphic designer hired by a trucking company may be a contractor. But a driver hired by that same company likely fails part B (driving is the company’s core business).

This test was popularized by the California Supreme Court’s decision in Dynamex Operations West v. Superior Court (2018) and later codified in Assembly Bill 5 (AB5).

Which States Use the ABC Test?

Not all states apply the ABC Test, and those that do may use it only for specific areas, such as unemployment insurance. Here’s a general breakdown:

States That Use the ABC Test Widely:

• California (AB5 applies broadly, though Prop 22 carves out some exceptions)
• Massachusetts
• New Jersey
• Connecticut
• Vermont
• Illinois (for wage and hour laws)
• Washington (for unemployment insurance)

States Using Modified or Partial ABC Tests:

• New York: Uses a version of the ABC Test for unemployment insurance but not wage laws.
• Oregon, Utah, Indiana: Similar hybrid models.

States Using the IRS/Common Law Approach:

• Texas, Florida, Georgia, and others primarily follow the IRS test or a very similar model for most classifications.

Federal vs. State: Which One Do You Follow?

Here’s where it gets tricky: you may be required to apply different tests for different compliance areas:

• For federal tax purposes, always follow the IRS Common Law Test.
• For state labor laws, follow your state’s classification rules - check with your state’s labor department.
• For multi-state businesses, you’ll need to navigate the laws of each state where you have workers

Example:

• A Massachusetts business hires a delivery driver. The IRS may classify the driver as a contractor. But Massachusetts’ ABC Test might require classifying them as an employee for wage and hour compliance.

To avoid legal trouble, many small businesses default to treating borderline workers as employees, even if it means higher costs.

How Contractors Can Be Used to Reduce Payroll Costs (Legally)

Despite the risks, contractors remain a valuable resource for small businesses. When used correctly, they offer flexibility, reduce overhead, and help businesses scale efficiently. Here's how to reduce payroll costs without getting into trouble with the IRS:

1. Hire Contractors for Non-Core, Specialized Work

• Example: Marketing consultants, freelance graphic designers, accountants, and web developers.
   
• This satisfies Part B of the ABC Test because the work is not part of your core business operations.

2. Focus on Project-Based Work

• Contractors should be paid only for the work they do, and should vary over time based on the amount & intensity of their work - but can not be paid a salary.
   
• Avoid dictating work hours or providing direct supervision.

3. Let Contractors Use Their Own Tools

• True independent contractors bring their own laptops, software, and workspaces.
   
• Requiring them to use company resources or report to a specific office can indicate employee status.

4. Avoid Long-Term Exclusivity

• Contractors should be free to work with other clients.
   
• If someone works for your company exclusively for an extended period of time, it looks more like an employer-employee relationship.

5. Have a Clear, Well-Written Contract

• Outline scope, payment terms, deliverables, and contractor independence.
   
• The contract should support, not contradict, the independent nature of the relationship.

By being intentional about how and why you engage contractors, you can safely reduce payroll burden without exposing your business to classification audits.

Why the Differences Matter

Misclassification penalties differ depending on who’s enforcing the rule:

• IRS: You may owe back taxes, interest, and penalties if you misclassify for federal tax purposes.
   
• State Agencies: You could owe back wages, unemployment contributions, or face lawsuits under state labor laws.
   
• Civil Liability: Workers can sue for unpaid benefits, overtime, or other protections.

Example: A New Jersey cleaning company classified workers as contractors but failed the state’s ABC Test. The company faced back payments to the state and had to pay unpaid overtime to workers after a DOL investigation.

Tips for Navigating Worker Classification

1. Start with Federal Rules: Always comply with IRS guidelines for tax withholding and reporting.
2. Check State Rules: Review whether your state uses the ABC Test and apply it when hiring or contracting.
3. Use Written Agreements - But Don’t Rely on Them Alone: Contracts help clarify roles, but don’t override the actual working relationship.
4. Don’t Misclassify to Save Money: Short-term savings can lead to long-term legal exposure.
5. Stay Informed: Employment laws are evolving. Several states and the DOL have proposed rules that shift definitions more in favor of employee status.

Conclusion: Know the Rules Before You Hire

As a small business, proper classification of workers isn’t just a compliance issue; it’s a business decision that affects your finances, liability, and reputation. Understanding the difference between the ABC Test, the IRS Common Law Test, and the legal difference between an employee & a contractor is key to staying out of legal trouble and building a fair, transparent workplace while keeping your payroll streamlined.

In our next and final article, we walk through how to properly document worker status, from onboarding to ongoing compliance, including sample checklists and contracts you can use to protect your business.