Two different tests can apply to this question, and if you operate in Massachusetts, you have to satisfy both. The federal IRS test is relatively forgiving. The Massachusetts ABC test is not. Getting this wrong is one of the most expensive mistakes a small business can make.

The federal IRS test looks at three categories: behavioral control, financial control, and the type of relationship. Behavioral control asks whether you direct how, when, and where the work gets done. Financial control looks at things like whether the worker has a significant investment in their own equipment, whether they can make a profit or take a loss, and whether they work for other clients. The relationship factor considers whether there is a written contract, whether you provide benefits, and whether the work is a key activity of your business. The IRS weighs all these factors together. There is no single factor that decides it.

Massachusetts uses the ABC test, and it is much tougher. Under this test, a worker is presumed to be an employee unless you can prove all three prongs. Prong A requires that the worker is free from your control and direction in performing the work. Prong B requires that the service is performed outside the usual course of your business. Prong C requires that the worker is customarily engaged in an independently established trade, occupation, or business of the same nature. You have to satisfy all three, and failing any one means the worker is an employee under Massachusetts law.

Prong B is where most service businesses run into trouble. If you run a cleaning company and hire someone to clean buildings, that work is clearly within your usual course of business. If you run a salon and bring in a stylist, cutting hair is your usual course of business. Under the Massachusetts ABC test, those workers are employees, even if they work for other clients and bring their own tools. The only way around it is if the work is genuinely outside what your company does. Hiring an electrician to fix wiring at your cleaning office could pass, since electrical work is not your business. Hiring a cleaner to clean buildings will not.

The consequences of misclassification are serious. You can owe back payroll taxes plus penalties and interest. Workers can file wage claims for overtime and benefits they should have received. The state can audit you for unemployment insurance and workers’ compensation. In Massachusetts, the penalties are steep and the enforcement is real.

For payroll, classification determines everything. If someone is an employee, you withhold taxes, pay employer taxes, and run them through payroll. If they are a contractor, you pay them directly and issue a 1099 at year end. Running someone as a 1099 when they should be W-2 does not actually save you money once the penalties and back taxes come due.

This is one of those areas where getting advice for your specific situation matters. The facts of each relationship determine the outcome, and what works for one worker might not work for another. If you have workers you are not sure about, bring your situation to someone who knows the rules. Smart Outsourced Solutions provides small business bookkeeping services and payroll for service businesses across New England and nationwide, and Simona can help you think through classification questions before they become problems.