As your small business grows, the flexible and cost-effective approach of hiring independent contractors may no longer serve your long-term needs or keep you in compliance with federal and state labor laws. At some point, you may find that a contractor’s role has expanded into something that legally resembles that of an employee.
In this final article of our series on proper worker classification, we’ll help you identify the key signs that it’s time to reclassify a contractor as an employee, outline the legal and strategic implications of doing so, and walk you through how to make the transition smoothly and compliantly.
Hiring independent contractors offers several advantages to small businesses as we have discussed in the previous articles in this series:
However, as your business matures and roles become more permanent, certain contractor relationships may no longer meet legal tests for independent work. Continuing to treat these workers as contractors (when they are functionally employees) can lead to tax audits, legal penalties, and back pay liability as was outlined in our previous articles.
Not every long-term contractor needs to become an employee. There are instances, however, in which a contractor begins their work in a way that directly meets that work status, but over time the situation may change due to increasing workloads, changes in project scope, or for other reasons.
Here are key indicators that the relationship has shifted beyond independent work and should be reclassified:
If you’re setting the contractor’s schedule, requiring daily check-ins, or training them on how to do the job, the IRS and state labor departments may consider them an employee.
If the contractor is performing work central to your company’s main service or product (for example, a driver for a delivery company or a software developer for a tech platform), they may fail the “usual course of business” test under state ABC rules.
Contractors are typically hired for short-term or project-based work. If they’ve worked continuously for months or years with no clear end date, the relationship may appear permanent.
Independent contractors usually serve multiple clients. If your contractor works only for you, uses your equipment, and is economically dependent on your business, reclassification may be necessary.
Supplying laptops, office space, or health benefits blurs the line between a contractor and employee and weakens your case for independent status.
Continuing to treat a misclassified contractor as an independent worker when they functionally qualify as an employee can lead to serious legal consequences:
One misstep can trigger audits from multiple agencies. If a single contractor files for unemployment or files a wage claim, it could open the door to a wider investigation.
When you determine it’s time to move a contractor to W-2 employee status, it’s essential to handle the transition with transparency, documentation, and care. Here's how:
Start by confirming that the contractor truly meets the legal definition of an employee under both:
Consult a labor attorney or tax advisor to avoid missteps.
Keep a written record explaining:
This documentation is useful if the IRS or a state agency ever audits your business.
Be honest and respectful. Many contractors will welcome the stability and benefits that come with W-2 employment. Explain:
Also, consider whether benefits like health insurance, retirement plans, or PTO are applicable based on their employment classification (full-time vs. part-time).
If you have a mixed workforce (some employees, some contractors), the reclassification of one worker could raise questions or concerns among others. Be proactive:
No. You cannot retroactively classify a worker as an employee for prior work already done under a 1099 agreement. But you can correct the course going forward.
In some cases, especially if there’s an IRS concern, businesses may qualify for the Voluntary Classification Settlement Program (VCSP). This IRS program lets you reclassify workers with reduced penalties and limited back taxes if you come forward voluntarily. It also provides partial relief from Federal employment taxes if the employer meets certain eligibility requirements and qualifies for the program. You should probably first consult with your tax professional if participating in the program makes sense for your situation.
Form 8952 for participation in the VCSP:
Here are some useful resources to simplify the process:
Reclassifying a contractor to an employee isn’t a failure; it’s often a sign of business maturity and responsible management. As roles evolve, staying in compliance protects your business, improves worker relationships, and ensures you’re building a strong foundation for long-term growth.
If you’ve followed the steps in this series, you now have:
Stay proactive, stay compliant, and your workforce strategy will serve both your business and your people well.
