How to Classify Workers Correctly and Avoid Legal Risk

Correctly classifying workers is one of the most important HR responsibilities for a small business owner. The difference between a 1099 contractor, an exempt employee, and a non-exempt employee determines how you pay taxes, handle overtime, and stay compliant with labor laws.

Misclassification can result in back taxes, penalties, and lawsuits, making it crucial to understand the rules before you hire.

Key Takeaways

• 1099 Contractors are self-employed workers responsible for their own taxes and not entitled to employee benefits.

• Exempt employees are salaried workers who do not receive overtime pay, provided they meet specific salary and job duties requirements under the Fair Labor Standards Act (FLSA).

• Non-exempt employees are protected by the FLSA and must be paid overtime for hours worked over 40 in a week.

• Misclassification can trigger IRS audits, legal penalties, and employee claims for back pay.

1099 Contractors

A 1099 contractor is an independent worker who provides services to your business but is not an employee. They control how the work is performed and are responsible for their own taxes and benefits. Business reports payments to independent contractors on a Form 1099-NEC (generally when the total payments to the contractor exceed $600 in a calendar year).

Diagnostic Indicators

• Control & Method: You do not direct the day-to-day means and methods of the work.

• Business Independence: They set their own schedule/rates, can realize profit or loss, and typically serve multiple clients.

• Tools and Expenses: They provide the tools/equipment and typically bear reimbursable expenses.

• Relationship: Project-based, non-permanent; no company benefits.

State Variations: Some states (e.g., CA) presume employee status unless the hiring entity satisfies the ABC test, a stricter standard than the federal common-law test.

Common Pitfalls

• Labeling core, ongoing roles as “contractors.”

• Dictating schedules, supervision, or processes as if they were employees.

• Failing to collect W-9s and issuing 1099-NEC forms when required.

Non-Exempt Employees

Non-exempt employees are covered by the Fair Labor Standards Act (FLSA) and must receive both minimum wage and overtime pay (1.5x their regular rate) for all hours worked over 40 in a workweek.

Diagnostic Indicators

• The employee does not meet all the requirements to qualify as exempt (Outlined under diagnostic indicators for exempt employees).

Other Considerations

• Pay Structure: They are paid hourly (or salaried but still eligible for overtime).

• Timekeeping: Hours worked must be recorded for payroll and compliance purposes.

• Overtime Requirement: Any hours beyond 40 in a workweek must be paid at time-and-a-half.

• Duties: Their job duties do not meet all the requirements to be considered exempt (see next section).

Exempt Employees

Exempt employees are exempt from FLSA overtime pay requirements because they meet all three exemption criteria: salary basis, salary level, and duties test.

Diagnostic Indicators

A worker is exempt if all the following are true:

• Salary Level: Their salary meets or exceeds the federal minimum (currently $684/week) or any higher state minimum.

• Duties Test: Their primary duties fall into one of the following categories:

  • Executive: Manages a department or business unit, regularly directs at least two employees, and has input into hiring/firing decisions.

  • Administrative: Performs office or business operations work involving independent judgment on significant matters.

  • Professional: Requires advanced knowledge in a field of science or learning (e.g., accountants, engineers, teachers).

  • Computer Professional: Highly skilled in systems analysis, software engineering, or programming (must meet specific pay rules).

  • Outside Sales: Primarily works away from the office, making sales or obtaining orders.

• Salary Basis: They receive a fixed salary not tied to hours worked.

Bottom Line

Each classification, including 1099 contractors, non-exempt employees, and exempt employees, has its own legal requirements. If you control the work and integrate the worker into your business, they’re probably an employee. From there, use the salary basis, salary level, and duties test to determine whether they are exempt or non-exempt. Getting it right protects you from costly backpay, fines, and litigation.