How to See 3 IRS Factors Before Misclassification Costs Money

Bookkeeping Tips, Hiring/Payroll, Podcast Episodes, Tax Strategies

Last updated September 29, 2026

The label on your contractor agreement matters less than the way you work with that person every day.

We do this episode going into the fourth quarter for a reason. Year-end gives you time to fix a contractor setup before January 1, and the alternative is finding out during an audit. Today I'm walking you through the test the IRS uses to tell a contractor from an employee, and what changes on payroll when you make the move.

Why the Agreement Isn't the Whole Story

I started with contractors, and so do a lot of the owners we work with. When you're first building a business, you need experts to come in and help, and there's nothing to standardize yet, so there's nothing to control. That changes once you have SOPs and a set schedule, because the person you're calling a contractor is now working inside your systems.

A signed agreement doesn't change that. If the working relationship says employee, the bill can include back payroll taxes and back benefits, plus penalties and interest.

The Three-Part IRS Test

The IRS gives us a clear test, and once you know it, the decision stops being a guess. Ask these questions about everyone you pay now and everyone you bring on later.

Behavioral control. When this person works with you, are you telling them how to do the work? If they follow your SOPs and brand guidelines and you give them ongoing feedback, that's employee behavior. At Kickstart, every client follows our SOPs and brand guidelines, so every member of our bookkeeping team is an employee.

Financial control. Who provides the equipment, and who sets the rate? A contractor quotes you a price and sends an invoice like their own business would. The more control you have over pay and hours, the more it looks like employment.

Relationship. Does this person operate their own LLC or corporation? Are they on a defined project, or is this open-ended and day-to-day? A long-term, day-to-day relationship leans employee.

None of these works in isolation, so look at all three together.

A Gut Check Before You Hire Or Run Payroll

Before you hire your next contractor or run your next payroll, picture yourself sitting across the table from an auditor. They're not always the friendliest people. Make your case out loud for why this person is a contractor. If you can't build that case with a straight face and a clear conscience, you already have your answer.

Moving someone to employee doesn't mean they have to be full-time, and you don't have to offer a full suite of benefits or have the entire handbook created. You do have to start moving away from the contractor relationship and toward an employee relationship.

If your contractors look like employees, that's a sign of growth. It happened to us at Kickstart. Once we had our SOPs and a set way of delivering for clients, we knew our contractors were employees.

What Changes When Someone Moves To Payroll

With a contractor, you collect a W-9 and send a 1099 at year-end, and they're responsible for both halves of their payroll tax, the employee half and the employer half. That's why our team tells every contractor client to set aside 25% of their net income for taxes.

Once someone is an employee, you set them up on payroll and the business pays the employer half. They'll pay less in payroll tax at year-end, and you take on that cost, so factor it in as you set their new rate. Explain the change before their first paycheck, and use the fourth quarter to get it done so they're on payroll as of January 1.

In this episode, you'll learn:

Why a signed contractor agreement doesn't settle the question
What behavioral control, financial control, and the working relationship each look at
How to run the auditor gut check on anyone you pay
Why moving a contractor to employee is a sign of growth
Who pays which half of payroll taxes and how to budget for the change

👉 Find out how our team can help you sort contractors from employees: here

Key Takeaways

0:00 Intro

2:21 The Three-Part IRS Test

4:31 The Auditor Test and Next Steps

7:35 Tax Impacts and Payroll Changes

9:02 Recap and Final Advice

If you check one thing before year-end, check who you're still calling a contractor.

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