Independent contractors can give growing businesses flexibility, specialized skills, and support for short-term projects. But the line between a contractor and an employee is not always as clear as it seems.
Misclassifying workers is one of the most consequential HR compliance risks SMBs face. A classification decision made informally, or never revisited, can lead to back taxes, penalties, and legal claims that are far more costly than getting it right from the start.
Employee Versus Contractor Classification Basics
Employee classification determines which protections and obligations apply to a working relationship, including minimum wage, overtime, payroll taxes, and unemployment insurance. A job title or signed contractor agreement does not settle the question on its own.
In February 2026, the U.S. Department of Labor proposed a rule that would rescind its 2024 independent contractor rule and apply an “economic reality” test. The proposal gives the most weight to two core factors: the nature and degree of control over the work, and the worker’s opportunity for profit or loss based on initiative or investment. Other factors include the skill required, the permanence of the relationship, and whether the work is part of an integrated unit of production. The proposal also emphasizes that actual practice matters more than what a contract allows.
The comment period closed in April 2026, so employers should watch for a final rule and review their practices once it is issued.
Financial and Legal Risks Associated With Misclassification
When a worker is misclassified, a business may become responsible for obligations it never budgeted for, such as unpaid payroll taxes, unemployment and disability insurance contributions, and overtime owed under wage and hour laws.
State enforcement can be significant. In March 2026, the New Jersey Department of Labor and Workforce Development announced a $7 million settlement with a last-mile auto parts distributor that had classified more than 1,000 delivery drivers as independent contractors. The company agreed to reclassify the drivers as employees and remain subject to state audits, with an additional $2 million in penalties suspended as long as it meets its obligations.
Beyond direct costs, misclassification disputes consume leadership time, erode employee trust, and can damage a company’s reputation.
Why Classification Becomes More Complex as Businesses Scale
Growth adds layers of complexity. A business that engages contractors in multiple states must consider more than one legal standard. As law firm Mayer Brown notes in its analysis of the federal proposal, states including California, New Jersey, Massachusetts, and Illinois apply the stricter “ABC test.” A worker who qualifies as a contractor under federal guidance may still be considered an employee under state law.
Roles also change over time. A contractor hired for a single project may gradually take on regular hours, ongoing responsibilities, and direct supervision, shifting the relationship closer to employment without anyone formally reconsidering it.
Steps SMBs Can Take to Review Worker Relationships
A regular classification review is one of the most practical ways to strengthen compliance for SMBs:
- Inventory every contractor. List each worker, their role, location, start date, and how long the engagement has lasted.
- Compare practice to paperwork. Assess who controls schedules, methods, and tools in day-to-day work, not just what the contract says.
- Check state requirements. Confirm which classification test applies where each worker is located.
- Document decisions. Record the reasoning behind each classification and revisit it whenever a role changes.
- Get expert guidance before acting. Reclassifying workers affects payroll, benefits, and onboarding, so changes should be planned carefully.
Reduce HR Compliance Risks With Humani
Worker classification is not a one-time decision. As regulations evolve and businesses grow, classification practices need regular attention.
Reduce HR compliance risks with Humani HR by scheduling a free consultation today.
