Employees and contractors: misclassification, overtime basics, written agreements, and why "1099 everyone" is the common mistake

The label does not decide it

Federal and state agencies and courts use several tests to decide whether a worker is an employee, and none of them starts with what the contract says. The IRS looks at behavioral control, financial control and the nature of the relationship. The Department of Labor looks at the economic reality of the relationship under the Fair Labor Standards Act. Many states use a stricter test that presumes employment unless the business proves the worker is free from its control, does work outside its usual business, and has an independent business of their own.

The common thread: a person who works your hours, uses your tools, follows your instructions, works only for you, and does the core work of your business is an employee under every test, whatever the paperwork says.

Why "1099 everyone" fails

Paying workers as contractors saves payroll tax, benefits and overtime in the short term. When a misclassified worker files a wage claim, or an agency audits, or the worker applies for unemployment and the state looks at the relationship, the business owes the back payroll taxes, the overtime it should have paid, often penalties and interest, and in a lawsuit the worker's attorney's fees. The saving is small and the bill is large, and in some circumstances it can be assessed against the owner personally, one of the holes in the shield described in how your business is exposed. A wage claim often arrives as a demand letter or an agency notice first; when a demand letter arrives covers the first week.

Overtime and the FLSA

The Fair Labor Standards Act, 29 U.S.C. § 201 and following, sets the federal minimum wage, requires overtime at one and a half times the regular rate for hours over 40 in a workweek for non-exempt employees, and requires employers to keep accurate time and pay records. States may set higher minimums and stricter overtime rules, and the higher standard applies.

The usual error is treating a salaried employee as automatically exempt from overtime. Exemption depends on both the duties the employee actually performs (executive, administrative, professional and a few others, each defined) and a salary threshold that has changed and been litigated; this course does not quote it. A salaried office manager who mostly does routine work is often not exempt. Misclassifying employees as exempt creates the same back-pay exposure as misclassifying them as contractors.

Written agreements

• Employees. An offer letter stating the role, pay, exempt or non-exempt status, start date and at-will status where your state allows it. A handbook with the policies you actually enforce. Confidentiality and, where enforceable in your state, non-solicitation terms.
• Contractors. A written agreement that reflects a real contractor relationship: a defined project or deliverable, the contractor's control over how and when the work is done, the contractor's own tools and other clients, payment by deliverable or invoice, and an assignment of intellectual property in the work product, which otherwise may stay with the contractor.
• Both. Signed, dated, and kept, like every other contract that holds up. An unsigned template in a shared drive proves nothing.

Other obligations that come with employees

Payroll tax withholding and deposits, workers' compensation insurance (required in most states for most employers), unemployment insurance, required workplace postings, anti-discrimination and anti-harassment rules that apply above small headcount thresholds, and leave laws that vary by state. An accountant and a payroll provider handle most of the mechanics. The decision about who is an employee is yours, and it is the one to get right first.