One of the first big questions businesses face when they start growing is this: Is my service provider an an independent contractor or actually an employee? It’s a common question, and an important one, because the distinction isn’t just about what title you give someone. It’s about taxes, legal obligations, and additional protections they may be afforded by their status under the law.

At Counsel Club, we work with freelancers, small studios, creative entrepreneurs, and growing businesses, so we’ve seen this question come up in all kinds of scenarios. Here’s what you need to know when making this decision.

Why the Employee vs. Contractor Classification Matters

When you hire someone as an employee, you’re taking on a set of legal and financial responsibilities. That includes:

• Payroll Taxes:

As an employer, you’re required to withhold federal and state income taxes, as well as Social Security and Medicare taxes from your employee’s paycheck. You’ll also pay your share of employment taxes. The form employees fill out to help with this is the IRS Form W-4, which determines how much tax to withhold.

To manage this, most businesses use a payroll provider (like Gusto or ADP), which calculates with holdings and files taxes on your behalf. While helpful, these services can be costly, something many early-stage businesses are wary of adding to their budget.

• Benefits & Legal Protections:

Depending on your state and the size of your business, employees may be entitled to:

• Health insurance (if you meet certain thresholds)
• Overtime pay under wage and hour laws
• Meal and rest breaks (especially in states like California)
• Unemployment insurance and workers’ compensation coverage
• Parental leave and other forms of protected leaves of absence
• Additional rights as a "protected class" under state and federal employment laws

Federal and state laws provide certain protections for employees. For example, in California, there are strict rules around minimum wage, overtime, and even requirements for meal and rest breaks. In contrast, some states have fewer employee protections, especially when it comes to at-will employment and wage laws.

Why Many Businesses Prefer Contractors (At First)

Given all those requirements, many businesses, especially startups, lean toward hiring independent contractors instead. Contractors are responsible for their own taxes, benefits, and work structure, which means:

• No payroll taxes for you to withhold
• No need to offer benefits
• Fewer legal compliance requirements
• Easier to management onboarding, offboarding, payment and other administrative matters

Sounds simple, right? Not so fast.

So What’s the Difference Between an Employee and a Contractor?

The key difference comes down to one word: control.

• Do you control how, when, and where the service provider does their work?
• Do you provide the equipment and tools they need?
• Can they work for other clients, or are they exclusive to you?

If you’re heavily involved in managing their day-to-day work, chances are they’re legally considered an employee, even if you’re calling them a contractor.

The Legal Tests

Both the IRS and the U.S. Department of Labor have guidelines to determine worker classification. The IRS uses a three-factor test focusing on:

1. Behavioral Control: Do you control how the work is done?
2. Financial Control: Do you control how they’re paid, whether expenses are reimbursed, or who provides tools?
3. Type of Relationship: Is the work ongoing? Are there benefits? Does the contract define the relationship clearly?

At the state level, the rules can vary. For example:

California uses the ABC Test, which is very strict. To classify someone as a contractor, you must prove that:

1. The worker is free from your control.
2. The work is outside the usual course of your business.
3. The worker is engaged in an independently established trade.

Florida, for example, on the other hand, applies a more flexible common-law test, focusing primarily on the degree of control and independence.

The bottom line: It’s not just what you call the worker, it’s what the relationship looks like in practice.

What’s the Risk of Misclassification?

Misclassifying an employee as an independent contractor can lead to serious legal and financial consequences, including:

• Government Audits: State labor departments or the IRS can audit your business. If they find that you’ve misclassified workers, you could owe back taxes, penalties, and interest.
• Unemployment Claims: This issue often surfaces when someone you’ve terminated files for unemployment benefits. If they were classified as a contractor, but the state determines they were actually an employee, you could be on the hook for unpaid employment taxes.
• Wage and Hour Claims: If a contractor claims they were actually an employee, they might sue for unpaid overtime, missed meal breaks, or other benefits they should’ve received.

How Businesses Handle the Gray Areas

Many businesses hire people as contractors during the early stages, especially when the work is project-based or temporary, the business is still growing, and there’s uncertainty around long-term roles or they want to minimize overhead costs. But as the relationship evolves, maybe the contractor is working exclusively for you, on a full-time basis, it might be time to re-evaluate and convert them to an employee.

For example, companies like Uber have faced years of litigation over whether drivers are truly independent contractors or employees, highlighting how complex these issues can get when a business scales.

How Counsel Club Can Help

At Counsel Club, we provide contractor agreements and employment agreements designed to reflect these legal nuances. Our contractor agreements include:

• Clear language stating the worker is an independent contractor
• Provisions confirming they’re responsible for their own taxes
• Clauses clarifying that you don’t control how contractors perform their work

But here’s the thing, having a contract isn’t enough. The reality and facts of the working relationship matters more than what’s written on paper.

The Takeaway

• Start with an agreement, whether it’s for a contractor or employee.
• Understand the legal tests in your state and at the federal level.
• Reassess as your business grows. A contractor today might need to become an employee tomorrow.

Counsel Club is here to support you as your business evolves, helping you navigate these decisions with confidence.