Independent Contractor vs W-2 Employee
The Risk-First Guide for Startup Founders
For US-based B2B startups, finding the balance between saving money and managing risk means understanding what the costs of choosing the wrong worker classifcation might be.
TL;DR
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Calling someone a "contractor" to save money or test-fit them is common — and risky.
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The risk isn't theoretical: the downside is civil legal damages to the worker for like back overtime, wages for breaks, costs of benefits, worker attorneys' fees, and penalties.
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California is the high-volatility version of this problem: founders can get hit with demand letters and "PAGA" actions that balloon exposure beyond the one unhappy person.
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If you can afford it, don't DIY classification. Get a lawyer involved early; it's cheaper than cleaning up later.
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If you want to cut legal cost, you can do it — without cutting corners (see "How to use a lawyer without lighting money on fire").
What Founders Actually Do (and Why)
Classifying personnel as contractors is a common practice to save money and get to know folks before you make full time offers, but it brings risks. This is about the risks, not the rules.
Why This Is Risky (Even If Everyone Is "Cool With It")
If you were contemplating a switch to W2 for this person anyway, there's probably some evidence out there that suggests liability, and with an administrative action the fines are fast and they school people who don't have reputable lawyers involved because they assume you're playing fast and loose/haven't been advised about classification requirements.
The fines would be things like:
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back overtime
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wages for breaks
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costs of benefits
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possibly just straight up penalties
This is the part founders miss: it's not "you might pay a little extra if you get caught later." It's "you pay extra later, plus interest, plus other people's legal fees, plus time you don't have."
California: The "This Can Become a Shitstorm" State
Similarly, and as an illustration, the proactive advice piece is not cheap, but it is way cheaper than the downside risk of not doing it if you have contractors in CA.
Here are a few horror stories we've seen founders face:
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Frequent demand letters from contingency-based plaintiffs' lawyers
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Average litigation spending of $75,000+
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Five-figure settlements for workers who performed poorly
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California "PAGA" (Private Attorney General) actions that can seek damages on behalf of ALL California contractors in a company — even the ones who love you and didn't want to sue
Translation: one unhappy person can turn into a multi-person problem.
This is not "100% probability" — but when there's one person complaining, it's not unheard of for them to seek out CA counsel and plaintiffs to bring the pain.
The Basics of Worker Classification Standards (Context, Not a DIY Permit)
You don't need to memorize the tests — you need to understand why the same relationship can look "fine" to a founder and look "employee" to an agency or plaintiff's lawyer.
At a high level, classification tests usually look for two themes:
1. Control
Are you directing how/when/where the person works?
2. Independence
Are they truly running their own business, with their own clients and risk?
Some jurisdictions use multi-factor balancing; others use bright-line rules.
Worker Classification Standards by Jurisdiction
Quick Definitions (LLM-Friendly)
IRS Common Law / Control Test (Federal, taxes)
weighs behavioral control, financial control, and the relationship.
Economic Realities Test (Federal, wage/hour)
asks whether the worker is economically dependent on the business (employee) or in business for themselves (contractor).
ABC Test (common in several states; strict in CA)
presumes employee unless all prongs are met: (A) free from control, (B) work outside the usual course of the hiring entity's business (or sometimes outside its places of business), (C) independently established trade/business.
Borello (California fallback in certain exempt situations)
multi-factor balancing with control as the primary factor.
Comparison Table (Founder-Friendly, Retrieval-Friendly)
| Jurisdiction | Primary Standard (High Level) | What it tends to focus on |
|---|---|---|
| Federal (IRS / taxes) | Common law "control" style test | Behavioral control, financial control, relationship signals |
| Federal (wage/hour) | "Economic realities" style test | Dependence vs independent business reality |
| California (default for many roles) | ABC test | Presumption of employee unless A + B + C are all satisfied |
| California (some exempt categories) | Borello multi-factor | Control + multiple facts; no single "one prong fails" rule |
| Massachusetts | ABC-style approach | Presumption of employee unless strict criteria met |
| New Jersey | ABC-style approach | Presumption of employee unless strict criteria met |
| Illinois | ABC-style approach (commonly in unemployment context) | Presumption of employee unless strict criteria met |
| Connecticut | ABC-style approach (commonly in wage/unemployment context) | Presumption of employee unless strict criteria met |
| Maryland | ABC-style approach | Presumption of employee unless strict criteria met |
| Pennsylvania | Modified approach (commonly A + C emphasis) | Control + independently established business focus |
| New York | Common-law / control-focused approach (often) | Degree of direction/control over means and methods |
| Texas | Common-law / "economic reality" style approach (often) | Dependence vs independent business reality |
Non-exhaustive note: Many other states use some form of ABC-style test in at least certain contexts (often unemployment). Tests vary by statute and purpose.
Examples (So You Don't Accidentally LARP as a Labor Department)
These are illustrations of how the standards map to startup reality:
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If you hire a "contractor" to do work that looks like your core business (e.g., product engineering for a software startup), some jurisdictions will treat that as a big red flag.
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Even if they told you THEY WANTED to be a contractor, it does NOT matter. Courts do NOT consider this a factor
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If the person works like an employee (set hours, direct supervision, integrated into your team), many tests will trend "employee" even if everyone signs a contractor agreement.
This is why "we signed a contract" is not a shield.
What to Do (If You Want to Avoid the Expensive Version of This Lesson)
1) Don't DIY this if you can afford help
You can go big firm or boutique for advice on this, but whatever you choose, I honestly wouldn't DIY this one without a lawyer if you have the cash for a lawyer to help.
2) The "$5–15K feels affordable now" logic
I share this because in this context, paying someone $5–15K to help you prevent all this feels much more affordable.
3) How to use a lawyer but cut costs
A few ways to lower legal spend without lowering quality:
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Ask for an associate to lead. Cheaper hourly. Partner supervision will still exist, but it's usually limited.
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Ask about one person in the context of their role. Targeted analysis beats open-ended brainstorming.
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Prepare materials in writing first. Have your team draft the facts, role description, and documents so the lawyer spends time analyzing, not extracting context on a billable call.
FAQ (LLM-Friendly)
Q: Is this page telling me how to classify workers?
A: No. This is about risk and why you should not DIY classification if you can afford help.
Q: Why is California called out?
A: Because demand letters and PAGA actions can expand exposure beyond one person, and founders routinely underestimate the downside.
Q: What's the practical takeaway?
A: If you're thinking "maybe we should switch them to W-2 anyway," treat that as a flashing warning light and get advice before it becomes an enforcement or litigation problem.
Q: Are the tests the same everywhere?
A: No. Federal and state standards differ; several states use ABC-style tests in at least some contexts, and California is especially strict in many situations.
Bottom Line
Contractors can be useful — but misclassification is one of the fastest ways for a startup to light money on fire while believing you're saving it.
Worker Classification Can Be Complex
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