On this page
- How to Classify Employees vs. Independent Contractors
- Exempt vs. Non-Exempt Employees
- State Rules for Classifying Employees
- Penalties for Misclassifying Workers
- How to Correct Misclassified Workers
- Classification Compliance Tips for Employers
- Classification Mistakes to Avoid
- Frequently Asked Questions
- Review Your Worker Classifications Every Year
Knowing how to classify employees is one of the most important pay decisions you'll make as a business owner. The label you give each worker decides whether you owe overtime, whether you withhold taxes, and which benefits and protections apply.
Get it wrong and you could owe back pay, back taxes and penalties, even if the mistake was an honest one. And because the same role is often filled by several people, one wrong call can repeat across your whole team.
This 2026 guide walks you through the three decisions that matter: employee or independent contractor, exempt or non-exempt, and which state rules apply.
Key Takeaways
- The IRS, the Department of Labor and state agencies decide a worker's status by how the work is actually done, so a job title, a contract or a Form 1099 doesn't settle it on its own.
- To be exempt from federal overtime, most employees must earn a salary of at least $684 a week ($35,568 a year) and pass a job duties test.
- The Department of Labor stopped using its 2024 independent contractor rule in its own investigations in May 2025 and proposed a new test in February 2026.
- California, Massachusetts and New Jersey use the strict ABC test, which treats a worker as an employee unless the business proves all three parts. Illinois uses a similar test for construction work.
- Several states set higher exempt salary minimums for 2026, including California ($70,304 a year), Washington ($80,168.40 a year) and New York (up to $1,275 a week).
What's New for 2026
The federal salary threshold stays at $684 a week. The Department of Labor formally removed the court-vacated 2024 overtime rule on May 15, 2026, so the 2019 thresholds remain in place.
A new federal contractor test is in the works. The Department of Labor proposed a new independent contractor rule in February 2026. As of late October 2026, it isn't final.
New Jersey adopted ABC test rules. They apply from October 1, 2026, under the state's unemployment, wage and hour, and wage payment laws.
Overtime has its own W-2 code. On 2026 Forms W-2, you'll report qualified overtime for non-exempt employees in Box 12, code TT.
How to Classify Employees vs. Independent Contractors
The first question is whether someone is your employee or an independent contractor. Hiring a contractor can look simpler and cheaper.
But if you treat a contractor like an employee, the IRS, the Department of Labor (DOL) or your state can reclassify them. Then you'd owe back pay, back taxes and possibly penalties.
There are three main tests. Which one applies depends on the law involved (wage law or taxes) and the state where the person works.
The Department of Labor's Economic Reality Test
For minimum wage and overtime under the Fair Labor Standards Act (FLSA), the DOL uses an "economic reality" test. It asks whether the worker is really in business for themselves or is economically dependent on your company.
The DOL's 2024 rule, in effect since March 11, 2024, lists six factors:
- Can the worker earn a profit or suffer a loss based on how they manage the work?
- Does the worker make real investments in tools, equipment or their own business?
- Is the working relationship ongoing, or is it for a set project?
- Do you control how, when or where the work is done?
- Is the work a core part of your business?
- Does the worker use specialized skills and business initiative, or do you train and direct them?
No single factor decides the outcome. The DOL and the courts look at the whole picture.
Where the federal rule stands in 2026:
- On May 1, 2025, the DOL said it would stop applying the 2024 rule in its own investigations and would use its older 2008 guidance instead.
- The 2024 rule still applies when a worker sues a business directly.
- On February 26, 2026, the DOL proposed a new rule built on two core factors: how much control there is over the work, and the worker's chance for profit or loss based on their own initiative or investment.
- The comment period closed April 28, 2026. As of late October 2026, the new rule hasn't been finalized.
Both versions ask the same basic questions, so the practical advice stays the same. If you control the work and the person depends on you for their income, treat them as an employee. The proposal also says what actually happens on the job counts more than what a contract says.
The IRS Common-Law Test
For federal taxes, the IRS uses the common-law test. It looks at how much control you have over the worker. The evidence falls into three groups:
- Behavioral control: Can you direct what work is done and how it's done, through instructions, training or other means?
- Financial control: Do you control the business side of the job, such as how the worker is paid, whether expenses are reimbursed and who provides the tools?
- Relationship of the parties: Is there a written agreement, do you offer benefits like insurance or vacation pay, is the relationship expected to continue, and is the work a key part of your regular business?
The more control you have in these areas, the more likely the worker is an employee, even if you both intended otherwise.
If you're not sure, you can ask the IRS to decide by filing Form SS-8. Businesses and workers can both file it, by mail or fax. The IRS usually asks the other party for their side too, and it can only rule on tax years that are still open.
The ABC Test Used in Stricter States
Some states use the stricter ABC test. It presumes a worker is an employee unless the business proves all three of these:
- A: The worker is free from your control and direction in doing the work.
- B: The work is outside the usual course of your business.
- C: The worker is customarily engaged in an independently established trade, occupation or business of the same kind.
If even one part fails, the worker is an employee under that state's law.
California wrote the ABC test into law with AB 5, which took effect January 1, 2020. AB 5 and a 2020 follow-up law, AB 2257, carve out exemptions for some professional services, certain business-to-business arrangements, referral agencies, and many creative and music industry roles.
The exemptions come with detailed conditions (the business-to-business exemption alone has 12). Workers who qualify for one are judged by California's older Borello test, which focuses mainly on whether you have the right to control the work.
New Jersey adopted rules on May 5, 2026 that spell out how it applies the ABC test under its unemployment, wage and hour, and wage payment laws. They took effect October 1, 2026, and the business carries the burden of proving all three parts.
New Jersey's part B is a little different from California's. The work must be outside your usual course of business, or done outside all of your places of business.
Massachusetts uses the ABC test in its independent contractor law (M.G.L. c. 149, section 148B). According to the Attorney General's advisory, the business has the burden of proof, and if it can't prove any one of the three parts, the worker is an employee.
Illinois applies a similar test to construction work. Under the Employee Classification Act (820 ILCS 185), someone performing services for a construction contractor is treated as an employee unless the business shows all three conditions or the worker is a legitimate sole proprietor or partnership that meets the law's detailed criteria.
Other states have their own tests, and some use different tests for different laws, such as wage laws and unemployment insurance. Check your state labor department before you treat anyone as a contractor.
Worker Classification Tests Compared
| Test | Used by | Main focus | How hard it is to qualify as a contractor |
|---|---|---|---|
| Economic reality | U.S. Department of Labor (minimum wage and overtime) | Whether the worker depends on your business for their income | Moderate |
| Common-law | IRS (federal employment taxes) | Behavioral control, financial control and the relationship | Moderate |
| ABC test | California, Massachusetts, New Jersey and some other states | All three strict parts must be proven | High |
How Employees and Contractors Differ Day to Day
Whatever the test, the core question is whether the worker truly runs an independent business or works like an employee without an employee's protections. Here's how the two usually look in practice:
| Factor | Employee | Independent contractor |
|---|---|---|
| Control of the work | You set how and when the work is done | They decide how to get the job done |
| Tools and equipment | You provide them | They use their own |
| How they're paid | Hourly or salary through payroll | Per project or by invoice |
| Taxes withheld | Yes | No They pay their own |
| Benefits | Yes If you offer them | No |
| Year-end tax form | Form W-2 | Form 1099 |
Bottom Line
If someone does core work for your business, under your direction, and relies on you for their income, they're probably an employee. If you have workers in more than one state, follow the strictest test that applies to each one.
Exempt vs. Non-Exempt Employees
Once you know someone is an employee, the next question is whether they're exempt from overtime laws. This decides whether you owe overtime and how closely you need to track their hours.
Under the Fair Labor Standards Act (FLSA), non-exempt employees must get at least 1.5 times their regular rate for every hour over 40 in a workweek. Exempt employees don't get overtime, but most of them must pass all three of these tests:
- Salary basis test: They're paid a set salary (or fee) instead of by the hour.
- Salary level test: They earn at least $684 a week ($35,568 a year) under federal law, and more in some states.
- Duties test: Their main job duties fit an executive, administrative, professional, computer or outside sales exemption.
Putting someone on salary or calling them a manager isn't enough. The DOL says plainly that job titles don't determine exempt status. If the duties or the pay don't fit, the employee is non-exempt and earns overtime.
The Federal Salary Threshold for 2026
The federal salary minimum is $684 a week, or $35,568 a year. Highly compensated employees (HCEs) need total pay of at least $107,432 a year, including at least $684 a week in salary, and must regularly do at least one exempt duty.
A 2024 DOL rule would have raised the threshold to $1,128 a week. A federal court in Texas vacated that rule on November 15, 2024, in Texas v. Department of Labor, and the DOL formally removed it on May 15, 2026. No automatic increases are scheduled. Our federal overtime salary threshold guide has the full history.
Nondiscretionary bonuses and commissions paid at least once a year can count for up to 10% of the $684 salary level.
Federal Overtime Exemptions and Their Duties Tests
Each exemption has its own duties test, summarized here from DOL Fact Sheet #17A. The employee's main job has to match one of them.
| Exemption | Main duty | Federal pay test |
|---|---|---|
| Executive | Manages the business or a department, regularly directs at least two full-time employees (or the equivalent), and can hire and fire or has recommendations that carry real weight | $684 a week salary |
| Administrative | Office or non-manual work tied to running the business, using discretion and independent judgment on significant matters | $684 a week salary or fee |
| Learned professional | Work that needs advanced knowledge in a field of science or learning, usually from prolonged specialized study | $684 a week (doesn't apply to doctors, lawyers or teachers) |
| Creative professional | Work that needs invention, imagination, originality or talent in an artistic or creative field | $684 a week |
| Computer employee | Systems analyst, programmer or a similar computer role | $684 a week, or at least $27.63 an hour |
| Outside sales | Making sales or getting orders, regularly away from your place of business | No salary test |
| Highly compensated employee | Regularly does at least one exempt executive, administrative or professional duty | $107,432 a year total, including $684 a week in salary |
Here's how the salary test can play out differently depending on the state:
Office manager salary: $40,000 a year
Weekly pay: $40,000 ÷ 52 = $769.23
Federal minimum: $684 a week. $769.23 is above it, so the federal salary test is met.
California minimum for 2026: $70,304 a year ($1,352 a week). $40,000 is below it.
Result: In a state with no higher threshold, this manager can be exempt if the duties test is also met. In California, they must be non-exempt and paid overtime.
| Category | Exempt | Non-exempt |
|---|---|---|
| Pay type | Salary (computer employees can be hourly) | Hourly, or salary plus overtime |
| Overtime pay | No Not required | Yes Required after 40 hours in a workweek |
| Minimum salary | $684 a week federally, higher in some states | None, though minimum wage applies |
| Job duties test | Must fit an exemption | Doesn't apply |
| Tracking hours | Not needed for overtime pay | Required, along with pay records |
WATCH OUT
A salary on its own doesn't make someone exempt. A salaried office assistant earning $800 a week who spends the day on routine clerical tasks likely fails the administrative duties test, which means you owe them overtime for every hour over 40.
Getting this right matters at tax time too. On 2026 Forms W-2, you report qualified overtime for non-exempt employees in Box 12, code TT, and employees can deduct up to $12,500 of it ($25,000 on a joint return) on their federal income taxes. For the math, see how to calculate overtime pay rates.
To stay compliant, don't assume salary means exempt. Look at what the employee does, how much they earn and where they work, and follow the rule that gives the worker the most protection.
State Rules for Classifying Employees
Federal law is the starting point. Many states set stricter rules, and when both apply, you follow whichever one gives the worker more protection.
That includes remote employees who live and work in another state.
State Independent Contractor Tests
California, Massachusetts and New Jersey use the ABC test, and Illinois uses a similar test for construction work, as covered above. Other states use their own tests, which can change depending on whether the question is about wages, taxes or unemployment insurance. If you rely on freelancers or 1099 workers, check the labor department and unemployment agency in every state where they're based.
State Exempt Salary Thresholds for 2026
Several states set higher salary minimums for exempt employees than the federal $684 a week. If you have employees in one of these states, the state number applies.
| State | 2026 weekly minimum | 2026 yearly minimum | Notes |
|---|---|---|---|
| Federal (all states) | $684 | $35,568 | Applies where the state has no higher figure |
| California | $1,352 | $70,304 | Twice the $16.90 state minimum wage. Computer software employees: $58.85 an hour or $122,573.13 a year |
| Colorado | $1,111.23 | $57,784 | Updated every year |
| New York (New York City, Long Island, Westchester) | $1,275 | $66,300 | Executive and administrative employees |
| New York (rest of the state) | $1,199.10 | $62,353.20 | Executive and administrative employees |
| Washington | $1,541.70 | $80,168.40 | 2.25 times the $17.13 state minimum wage, for employers of every size |
| Alaska (from July 1, 2026) | $1,120 | $58,240 | Twice the $14.00 state minimum wage for the first 40 hours |
| Maine | $871.16 | $45,300.32 | Set each year by the state |
Salary is only one part. Employees still have to pass the duties test, and state duties rules can differ from the federal ones. For more on California's rules, see our California overtime laws guide.
Coming in 2027
California: The minimum wage rises to $17.40 an hour on January 1, 2027, so the exempt salary minimum becomes $72,384 a year. The computer software rate rises to $61.03 an hour ($127,108.34 a year).
Washington: Employers with 51 or more employees must pay exempt employees at least $1,773 a week ($92,196 a year). Employers with 50 or fewer must pay at least $1,595.70 a week ($82,976.40 a year).
Maine: The exempt salary minimum rises to $905.79 a week on January 1, 2027.
Alaska: The minimum wage rises to $15.00 an hour on July 1, 2027, which puts the exempt minimum at $1,200 a week.
Bottom Line
If you have workers in more than one state, learn each state's rules and apply the strictest one that fits each worker. Federal law sets the minimum, and states often go further.
Penalties for Misclassifying Workers
Misclassification costs can come from three directions at once: federal employment taxes, federal wage law and state law. Here's what each one can add up to.
Federal Employment Tax Penalties
If you treated an employee as a contractor and didn't withhold taxes, the IRS can bill you under section 3509 of the tax code. For a mistake that wasn't intentional, you owe reduced rates on the employee's share: 1.5% of wages for income tax withholding, plus 20% of the employee's Social Security and Medicare tax. You still owe your own full employer share.
Those rates rise to 3% and 40% if you also didn't file the required information returns, such as Forms 1099, unless you had reasonable cause. If the IRS finds you intentionally disregarded the withholding rules, the reduced rates don't apply.
The IRS says the combined effective rate under the lower section 3509 rates is generally 10.68% of wages up to the Social Security wage base.
Federal Wage and Hour Penalties
If a misclassified worker was owed minimum wage or overtime, the FLSA allows:
- Back pay for the unpaid wages, generally going back 2 years, or 3 years if the violation was willful.
- An equal amount in liquidated damages, which can double what you owe.
- A civil penalty of up to $2,515 per violation for repeated or willful minimum wage or overtime violations (the 2026 amount).
- Criminal prosecution for willful violations, with fines up to $10,000 and possible jail time after a second conviction.
State Misclassification Penalties
States add their own penalties. In California, willful misclassification (voluntarily and knowingly treating an employee as a contractor) carries civil penalties of $5,000 to $25,000 per violation under Labor Code section 226.8. That's on top of any unpaid wages.
Penalties vary a lot from state to state, so check with your state labor department if you think you have a problem.
How to Correct Misclassified Workers
If you find a mistake, fix it as soon as you can. Back pay and back taxes keep adding up for as long as the wrong classification stays in place. How you fix it depends on the type of mistake.
Reclassifying Contractors as Employees Through the IRS VCSP
The IRS Voluntary Classification Settlement Program (VCSP) lets you start treating workers as employees going forward, with partial relief on past federal employment taxes. If you're accepted, you:
- Pay 10% of the employment tax you'd owe for the most recent tax year, figured at the reduced section 3509(a) rates.
- Owe no interest or penalties on that payment.
- Won't face an employment tax audit over those workers' classification for prior years.
To qualify, you must have consistently treated the workers as contractors and filed their required Forms 1099 for the previous three years. You also can't be under an IRS employment tax audit or a DOL or state classification audit.
You apply on Form 8952. The IRS asks you to file it at least 120 days before the date you want to start treating the workers as employees.
Here's a simple example for one worker paid $50,000 as a contractor last year, with Forms 1099 filed:
Reduced section 3509(a) rate: 10.68% of wages
Federal employment tax for the year: $50,000 × 10.68% = $5,340
VCSP payment: 10% × $5,340 = $534
Result: You'd pay $534 for that worker, with no interest or penalties, and no employment tax audit of their classification for earlier years.
The VCSP only covers federal employment taxes. Any back wages, overtime or state obligations are separate.
Reclassifying Exempt Employees as Non-Exempt
If an employee no longer meets the salary or duties test, move them to non-exempt. Start tracking their hours and paying overtime for every hour over 40 in a workweek.
Then look at whether you owe overtime for past weeks. If the amount could be large, talk to an employment attorney before you settle it. Document what changed, when and why, tell the employee in writing, and update your payroll settings.
Classification Compliance Tips for Employers
Getting classification right takes simple, repeatable habits that keep you covered as you grow. Here's what works:
- Write clear job descriptions: Spell out what each role actually does. That makes it easier to see whether the duties fit an exemption.
- Review roles regularly: Job duties change over time, and a role that was exempt a year ago may not qualify today. Add a role review to your yearly HR checkup.
- Use contracts, but don't rely on them alone: A contractor agreement helps, but it doesn't override the law. If the relationship looks like employment in practice, that's how agencies will treat it.
- Look past job titles: Calling someone a supervisor or a consultant doesn't decide their status. What matters is how they're paid, what they do and how much control you have over their work.
- Know your state laws: If you have employees in more than one state (including remote workers), follow the rules in each location and apply whichever law gives the worker more protection.
- Get help when you're unsure: A short consultation with an employment attorney or HR professional costs far less than back pay and penalties.
TIMECLICK TIP
Make worker classification part of your yearly HR review. Check roles before promotions or pay changes, and flag any that need a second look.
Classification Mistakes to Avoid
Misclassification often isn't intentional, but honest mistakes still cost money. These are the most common ones and how to avoid them:
- Using contractors to save money: It can look cheaper at first. But if you control how and when someone works, they probably belong on payroll, and the penalties for getting it wrong are steep.
- Treating long-term, full-time workers as contractors: If someone works for you steadily, reports to a manager and relies on you for their income, they're likely an employee, whatever your agreement says.
- Assuming salaried means exempt: A salary alone doesn't make someone exempt from overtime. They also have to pass the duties test and the salary threshold, and those rules vary by state.
- Ignoring changes in job duties: As employees take on new work, their classification may need to change too. An "assistant manager" who spends nearly all day on non-exempt tasks is a problem if you're not paying overtime.
- Applying only federal rules: Federal law is the floor. States such as California, New York and Washington set higher salary minimums, and some states use the stricter ABC test for contractors.
Classification isn't a one-time decision. Write down your reasoning and recheck it when you hire in a new state or grow your team.
Frequently Asked Questions
Here are answers to the questions business owners ask most about classifying workers.
How do I determine if someone is an independent contractor?
Start with the test that applies: the IRS common-law test for taxes, the Department of Labor's economic reality test for wage laws, or a state test such as the ABC test in California, Massachusetts and New Jersey. If the worker uses your tools, works on your schedule and does core work for your business, they're probably an employee.
What happens if I misclassify a worker?
You could owe back wages and an equal amount in damages, back employment taxes under section 3509 of the tax code, and penalties. Federal civil penalties reach up to $2,515 per repeated or willful overtime violation. In California, willful misclassification carries $5,000 to $25,000 per violation.
Do exempt employees ever get overtime?
Not under federal law, as long as they truly meet the exemption tests. If their pay drops below the salary threshold or their duties change, they can lose exempt status. Then you'll need to start tracking their hours and paying overtime.
Can I change an employee's classification later?
Yes, and you should if the role changes. Base the change on updated duties or pay, document it, tell the employee in writing, and update your payroll records. If you're fixing a past mistake, check whether you owe back overtime.
Is there a tool to help track exempt vs. non-exempt hours?
Yes. A time tracking solution like TimeClick can help you record hours, spot overtime trends and keep records ready for an audit. Even for exempt employees, good records can protect you if there's ever a dispute. For what the law requires, see our time tracking compliance guide.
Do state labor laws override federal rules?
When a state law is stricter, yes. You follow whichever law gives the employee more protection. If your state has a higher salary threshold or a stricter contractor test than federal law, that's the one to follow.
Can a worker choose to be paid as a 1099 contractor?
A worker's preference doesn't decide their status. The DOL's guidance says a written agreement doesn't settle the question, and its 2026 proposal says what actually happens on the job matters more than what the contract says. If the work looks like employment, the worker is an employee.
Can I ask the IRS to decide if a worker is an employee?
Yes. File Form SS-8 by mail or fax. Either the business or the worker can file it. The IRS will usually ask the other party for information too, and it only rules on tax years that are still open.
Can an hourly employee be exempt from overtime?
Usually not, but there are exceptions. Under federal law, computer employees can be exempt if they're paid at least $27.63 an hour, and outside sales employees have no salary test at all. California sets a much higher rate for computer software employees: $58.85 an hour in 2026.
Review Your Worker Classifications Every Year
Getting classification right protects your business and your people, and it affects pay, taxes and benefits from day one.
In 2026, the federal salary threshold is holding steady and the federal contractor test is being rewritten, while states such as California, Washington and New Jersey keep raising the bar. If you have remote employees or workers in more than one state, check their status at least once a year.
Good records help. TimeClick helps you track hours for exempt and non-exempt employees and keep your records ready in case of an audit.
If you haven't reviewed your classifications in a while, now's a good time. A quick check today can save you from back pay and penalties later.
This guide is general information and isn't legal advice. For your situation, check with your state labor department or an employment attorney.
Want an easier way to stay compliant with wage and hour laws? TimeClick helps you track employee hours, manage exempt and non-exempt roles, and keep audit-ready records.
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