Hiring independent contractors can be one of the smartest business decisions if done correctly. Contractors bring in specialized skills, allow you to scale up or down quickly, and save costs because you don’t have to cover payroll taxes, benefits, or long-term commitments.

But the law draws a sharp line between an independent contractor and an employee. It’s not about what you call them—it’s about how the working relationship is structured. If you get it wrong, the IRS, Department of Labor (DOL), or even state agencies can penalize you for worker misclassification.

So, how do you hire contractors legally?

• Know the difference. Contractors run their own business, control their work, and pay their own taxes. Employees work under your control, use your tools, and rely on you for benefits and steady pay.
  
• Follow legal tests. Federal and state agencies use specific frameworks (IRS test, DOL test, ABC test) to determine contractor status.
  
• Put everything in writing. Contracts protect you by spelling out that the person is an independent contractor, not an employee.
  
• Stay consistent. Treat contractors like contractors: pay invoices, don’t put them on payroll, and don’t manage them like employees.

👉 If you’re new to compliance, start with our main guide on Hiring Guidelines for US Employers.

Independent Contractors vs. Employees: What’s the Difference?

The biggest compliance risk when hiring contractors is misclassification. Many employers treat workers like employees (setting schedules, giving benefits, supervising daily tasks) but label them as contractors to save costs. That’s illegal.

Here’s the basic distinction:

Independent Contractor	Employee
Controls how, when, and where the work is done.	Employer controls work hours, location, and process.
Paid per project or deliverable.	Paid hourly or salaried, on a regular schedule.
Provides their own tools/software.	Employer provides tools and resources.
No benefits (health insurance, PTO, retirement).	Eligible for benefits and protections.
Responsible for their own taxes.	Employer withholds taxes and files payroll.

Quick tip: If you’re telling someone how to do the job instead of just what needs to be done, they’re probably an employee.

👉 For more on employee compliance, see How to Legally Hire an Employee in the USA.

Legal Tests for Determining Contractor Status

It’s not up to the employer to simply decide who’s a contractor. Agencies use established tests to evaluate the relationship. Understanding these tests is key to staying compliant:

1. IRS Common Law Test

The IRS focuses on three areas:

• Behavioral Control – Do you dictate how, when, and where the person works? If yes, they’re likely an employee.
  
• Financial Control – Who decides how the worker is paid, whether they can profit or lose, and if they can work for others? Contractors typically control these aspects.
  
• Relationship – Is there a contract? Are benefits provided? Does the arrangement look permanent? Employees usually have open-ended relationships; contractors are project-based.
  

2. Department of Labor (DOL) “Economic Realities Test”

This test examines whether the worker is economically dependent on the business. If most of their income comes from you, or if they don’t operate as a true business, they may actually be an employee.

Key factors:

• The permanency of the relationship.
• The degree of control you have.
• The worker’s investment in tools or equipment.
• Whether the work performed is integral to your business.

3. ABC Test (Used in Some States Like California and Massachusetts)

This is the strictest test. A worker is an independent contractor only if all three conditions are met:

A. They’re free from your control and direction.
B. They perform work outside your usual business (e.g., a coffee shop hiring a plumber).
C. They are engaged in an independent trade or business (e.g., they advertise services, have multiple clients).

👉 States like California enforce the ABC test aggressively. Even if federal law says someone could be a contractor, state law may override it.

Steps to Legally Hire Independent Contractors

To protect your business, follow these steps when hiring independent contractors:

Step 1: Clearly Define the Role

Ask yourself: Is this truly project-based work, or do I expect this person to function like an employee? Contractors are best for short-term projects, specialized expertise, or flexible workloads.

Step 2: Draft a Contractor Agreement

A written contract is your strongest protection. It should include:

• Scope of work (specific tasks or deliverables)
  
• Payment structure (per project, milestone, or hourly rate)
  
• Timeline or project deadlines
  
• Statement of independent contractor status (not an employee)
  
• Responsibility for taxes, insurance, and expenses
  
• Ownership of intellectual property (if relevant)
  

Step 3: Collect the Right Tax Forms

• Form W-9 – Collect this from contractors to get their Tax ID or Social Security number.
  
• Form 1099-NEC – If you pay them more than $600 in a year, you must issue this at year’s end.
  

Step 4: Pay Invoices, Not Payroll

• Contractors send invoices for completed work.
  
• Never run them through payroll or withhold taxes.
  
• Let them control when and how they bill.
  

Step 5: Keep Detailed Records

• Store contracts, W-9s, invoices, and payments.
  
• Documentation is critical in case of an IRS or DOL audit.
  

👉 For employee-specific hiring rules, see How to Legally Hire an Employee in the USA.

Common Mistakes Employers Make with Contractors

Even experienced employers fall into traps when managing independent contractors. Here are the most common mistakes to avoid:

1. Treating Contractors Like Employees
   
   • Setting fixed schedules, requiring office attendance, or supervising daily tasks.
     
   • Example: Asking a freelance writer to “clock in at 9 AM every day.” That’s employee behavior.
     
2. Providing Employee Benefits
   
   • Offering health insurance, PTO, or retirement contributions undermines contractor status.
     
3. Using Contractors for Core Business Roles
   
   • If the person’s work is integral to your business (e.g., hiring a full-time barista as a “contractor” for a coffee shop), they should likely be classified as an employee.
     
4. Relying on a Single Contractor Too Much
   
   • If someone works for you exclusively, regulators may view them as an employee.
     
5. Ignoring State Laws
   
   • States like California have much stricter rules than federal law. A contractor under the IRS test might still be an employee under the ABC test.
     

👉 For a structured approach to compliance, use our HR Compliance Checklist for US Employers.

Why Getting It Right Matters

Worker classification is more than a paperwork issue—it has real consequences for both your business and your contractors.

If you misclassify workers, you could face:

• Financial penalties – Back taxes, unpaid Social Security, Medicare, and unemployment contributions.
  
• Employee claims – Contractors could sue for unpaid overtime, benefits, or wrongful termination.
  
• Audits and investigations – IRS and DOL audits can drain time and money.
  
• Reputation damage – Lawsuits or fines can harm your employer brand and make future hiring harder.
  

If you classify workers correctly, you benefit from:

• Flexibility – Contractors can be hired for short projects without long-term commitments.
  
• Cost savings – No payroll taxes, benefits, or unemployment insurance required.
  
• Access to talent – Many professionals prefer contract work because it allows freedom and multiple income sources.
  

👉 For deeper legal context, see The 3 Most Important HR Laws in the USA Explained.

FAQs on Hiring Independent Contractors in the USA

Q1. Can I hire both employees and independent contractors in my business?
Yes, but make sure you’re classifying them correctly. Employees follow company schedules and receive benefits, while contractors work independently.

Q2. Do independent contractors need to sign a contract?
Absolutely. A written agreement protects both parties by clearly defining responsibilities, pay, and contractor status.

Q3. Do I need to withhold taxes for contractors?
No. Contractors handle their own income taxes and self-employment taxes. Your responsibility is to issue a 1099-NEC if you pay them $600 or more in a year.

Q4. What happens if I misclassify a worker?
You could owe back taxes, benefits, and penalties, and face lawsuits. The IRS and DOL take misclassification very seriously.

Q5. How do state laws affect hiring contractors?
Some states (like California) use stricter rules, such as the ABC test, making it harder to hire contractors legally. Always check both state and federal requirements.