Employee vs. Contractor: What's the Difference and Why It Matters

How you classify the people who work for you, employee or contractor, determines your legal obligations, your tax exposure, and theirs. California has the strictest worker classification standard in the country, and getting this wrong is one of the most common and costly payroll mistakes a small business can make.

The Core Difference

California's ABC Test (AB5)

California uses the ABC test under Assembly Bill 5 (AB5), significantly stricter than the federal standard. All three parts must be true for a worker to be classified as an independent contractor in California:

A — Free from control

The worker is free from the company's control and direction in performing the work, both under the contract and in actual practice. You cannot tell them when to work, how to do the work, or supervise their methods.

B — Outside the usual course of business

The worker performs work that is outside the usual course of the company's business. A bookkeeper hiring a graphic designer to redesign their logo: contractor. A bookkeeper hiring another bookkeeper to handle overflow client work: likely an employee under the ABC test.

C — Independently established trade or business

The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed. They have other clients, market their services, and operate as a real business, not just working for you.

If any one of the three parts is not met, the worker is an employee under California law.

Exemptions from AB5

Some professions are exempt from the ABC test and may qualify as contractors under a different standard (usually the prior Borello multi-factor test). Common exemptions include:

• Licensed professionals: doctors, dentists, lawyers, architects, engineers, accountants, insurance agents
• Real estate licensees
• Financial services
• Some creative professionals (with additional conditions)

If the worker's profession has an exemption, classification is still not automatic, it requires meeting that profession's specific criteria. Confirm with your NCO advisor.

The Federal Standard

For federal tax purposes, the IRS uses a common-law test based on behavioral control, financial control, and the type of relationship. California's ABC test is generally stricter, if a worker qualifies as a contractor under AB5, they almost certainly qualify at the federal level too. The reverse is not always true.

Why Misclassification Is Risky

If the IRS or the EDD determines someone you classified as a contractor was actually an employee:

• You owe all the payroll taxes that should have been withheld and remitted, back to when the relationship started
• You owe the employer's share of Social Security and Medicare
• Workers' compensation liability applies retroactively
• Penalties and interest on top of everything above
• The worker may be entitled to unpaid overtime, meal/rest break premiums, paid sick leave, and other California employment law protections

EDD audits are common in California and often triggered by a worker filing for unemployment. The exposure can cover multiple years and multiple workers.

Abnormal Procedures

You've been treating someone as a contractor but you're not sure they qualify under AB5.

Stop and get a proper assessment before the relationship continues. Ask your NCO advisor to review the arrangement. Do not continue the engagement under contractor status while the question is unresolved.

You want to convert a contractor to an employee.

Set a clear transition date. From that date forward, set up payroll, collect a W-4 and DE 4, and start withholding taxes. Do not try to back-date the conversion without first getting advice on the tax implications.

The worker insists they want to be treated as a contractor.

The worker's preference doesn't change the legal analysis. If the working arrangement meets the tests for employment, calling it a contractor relationship doesn't make it one. Both parties take on risk, but as the hiring business, the liability for unpaid payroll taxes and employment law violations falls on you.

FAQ

Can I have someone sign a contract saying they're a contractor?

A written contract is evidence, but not conclusive. If the actual working arrangement looks like employment, the EDD and IRS can override the contract. Substance controls, not labels.

What if the contractor has their own LLC or corporation?

It helps, but it doesn't automatically make them a contractor under California law. The ABC test applies regardless of the worker's business structure. An incorporated worker can still fail part B of the test if their work is within the usual course of your business.

Do I need to issue a 1099-NEC for contractors?

Yes, if you paid them $600 or more during the calendar year. Get a completed W-9 from every contractor before you pay them, you'll need their legal name, address, and SSN or EIN to file the 1099-NEC. See: How to Prepare and File 1099s.

What about out-of-state contractors working remotely for a California business?

California AB5 applies based on the nature of the work and relationship, not just where the worker sits. If the business is in California and the work is integral to that business, California classification rules can still apply. Get advice before treating remote out-of-state workers as contractors.