The number of people performing at least some form of independent work in the US more than doubled between 2017 and 2023. Over the past decade, both employers and workers have begun seeing the benefits of a more flexible approach to work. But engaging independent workers carries significant risks for a company — read on for our guide to contractor compliance in 2025.
Contractor compliance requirements: an overview
Proper contractor compliance involves ensuring all workers are correctly classified, as well as meeting tax, labour and employment rules. Companies hiring independent contractors in the USA need to abide by a range of state and federal regulations. Some of the most important regulations that employers should be aware of include:
- The Internal Revenue Service (IRS) guidelines
- The Fair Labor Standards Act (FLSA)
- California AB5 (ABC Test)
Depending on where you’re located, there may be other state-level regulations in play. Understanding the rules that apply to your business can help you avoid legal repercussions such as fines and penalties, as well as other consequences of non-compliance.
Challenges and solutions in contractor classification and management
Correctly classifying and appropriately managing independent contractors is a complex business — but you can’t afford to get it wrong. Here’s what you need to know about contractor compliance in 2025.
Understanding worker classification in the USA
In the US, most workers are W-2 employees. This means that their employers are responsible for:
- Withholding and remitting the correct taxes and charges
- Providing healthcare, insurance and other mandatory benefits
- Setting the employee’s schedule and directing their work
Employers can also choose to take on workers as independent contractors. Unlike employees, contractors are responsible for managing their own schedules and calculating and remitting their own taxes. They’re not usually entitled to the same benefits and protections as W-2 employees.
Independent contractors in the US can be either corp-to-corp (C2C) contractors (who work through incorporated companies) or 1099 contractors (who don’t). 1099 workers may also be referred to as freelancers or sole proprietors.
Some US companies deliberately misclassify employees as independent contractors to avoid paying taxes and providing benefits, which is known as disguised employment. However, correctly classifying workers is not always as simple as it might seem, and even well-meaning businesses must be careful to avoid misclassification.
Navigating tax obligations for US contractors
In the US, employers are responsible for withholding income taxes, Social Security taxes and Medicare taxes from the wages they pay their W-2 employees. They must remit these to the relevant authorities along with their matching Social Security and Medicare contributions and unemployment tax (paid solely by the employer).
None of this is required for independent contractors. That means that worker misclassification can deprive the Internal Revenue Service (IRS) of tax revenue that it would be owed if the workers were correctly classified as employees. For this reason, the IRS takes issues of employee misclassification very seriously.
To determine the right tax treatment for their workers, employers must consider whether they are viewed as employees or independent contractors in the eyes of the IRS. To help employees with these determinations, the IRS has published a set of guidelines called the ‘common law rules’. However, correctly classifying a worker is not always straightforward.
Rights and benefits for contractors vs. employees
When workers are incorrectly classified as independent contractors, they miss out on the protections, benefits and rights that they would be entitled to as employees. This includes things like:
- Paid time off
- Minimum wages
- Health insurance
- 401(k)s
- The right to unionise
- Health and safety provisions
- Overtime pay
This is another reason that employee misclassification is a serious issue — even if it’s not done on purpose.
Why it matters: the risks of misclassifying workers
For the reasons discussed above, the consequences of misclassifying employees as independent contractors can be severe. For example, they can include:
- Backdated taxes: Employers may be asked to backpay the federal, state and local taxes they owe based on the entire duration of the disguised employment relationship.
- Back pay of wages including overtime: If employees didn’t receive at least the minimum wage, they may be entitled to backpay, including overtime. Again, this would cover the entire length of their engagement.
- Backdated employment benefits: Similarly, employers may have to backpay benefits the worker should have received, including monthly healthcare contributions, PTO and sick leave.
- Legal consequences: Employers that have misclassified employees can be taken to court and made to pay huge fines and penalties. In very serious cases, individuals involved in the case can face criminal charges.
- Reputational damage: Businesses that become known for misclassifying workers are likely to face significant reputational damage. This can lead to problems attracting and retaining workers in the future.
The exact consequences of employee misclassification depend on the state where your business is based. Factors like whether the misclassification was deliberate, how long it went on and how many workers were involved may also be considered. Over the past few years, there have been several high-profile cases of employee misclassification, with companies like Uber and Nike being made to pay significant penalties.
5 best practices for contractor compliance in 2025
Want to ensure contractor compliance in 2025? Here are some best practices to follow.
1. Determine classification guidelines
Every business should have a clear framework in place for classifying workers. This should be based on IRS, DOL, and state-level guidance. To ensure contractor compliance, it’s important to research the rules that apply in your state. For example, we’ve already talked about the ‘common law’ rules used by the IRS.
As of March 2024, the Department of Labor (DOL) uses something called the ‘six-factor test’ to determine worker statuses. As the name suggests, this test assesses the economic dynamics between an employer and a worker according to six factors.
Another important standard is the ‘ABC’ test, which is outlined in the California Assembly Bill 5 (AB5). This statute requires employers to submit workers to a simple, three-part test to determine their status. Workers must meet all three criteria to be considered independent contractors. While the ABC test originated in California, it’s now used in more than 30 states.
2. Implement formal written agreements
Employee classification cases are judged based on the actual facts of the situation, not just the contract or agreement in place. However, a formal written agreement can serve as a strong legal foundation for independent contractor status, as well as acting as a reminder to managers about each worker’s classification.
Agreements should outline the scope of work, payment terms and expectations. They should also clearly state that the worker is responsible for managing their own schedule and workload. For help creating localised, compliant agreements for independent contractors, consider working with a contractor management partner like CXC.
3. Conduct regular compliance audits
Many businesses take care to correctly classify contractors at the beginning of their engagements — but working practices can change over time. Conducting regular reviews into each worker’s terms of engagement, financial independence and the level of control the company has over them can help ensure continued compliance. This process is extensive, and many companies need to seek external help. A compliance partner like CXC can assist you by conducting unbiased evaluations, identifying risks and implementing solutions promptly.
4. Provide training and education
Managers can land your company in hot water if they don’t understand the difference between employees and independent contractors (or why it matters). That’s why providing regular and thorough training is such a crucial part of contractor compliance in the US.
This training should cover key legal principles related to worker classifications and what this means in practice for your organisation. It should be regularly updated to ensure it reflects the latest regulatory changes. Putting together self-service resources like guidebooks, manuals and online training courses is also a good idea.
5. Leverage technology or work with external partners
Leveraging the right tools to streamline the contractor compliance process can save a lot of time. For example, contractor management software can automate the classification process, track payments and other important data and provide a clear record for future audits.
If you want to take things a step further, consider partnering with an experienced compliance provider like CXC. Outsourcing contractor compliance to a trusted third party helps ensure your operations meet regulatory requirements without increasing the administrative burden on your internal team.
Preparing for future trends in compliance management
Independent contractor compliance is not a one-time job. Rules and regulations are constantly evolving, and it’s quite possible that a worker who would have been considered an independent contractor several years ago would receive a different determination today.
But when it comes to compliance with the law, ignorance of the latest changes is no excuse. That’s why it’s crucial to take a proactive approach to compliance, keeping an eye on upcoming regulatory updates and considering how they’ll impact your business.
It’s also important to remember that compliance is not just a job for HR — or any other department. Companies that are serious about success in this area must build a culture of compliance that spans the entire organisation. Put simply, everyone who comes into contact with independent contractors should have at least a basic understanding of the company’s compliance obligations and why they matter.
Ensuring smooth and compliant contractor management in 2025 and beyond
Contractor compliance is crucial to safeguarding your business from risks like fines, penalties and serious reputational damage— but it’s also a lot of work. Working with an experienced external compliance partner can help you stay abreast of regulatory changes and maintain compliance without a significant time investment. This gives you the freedom you need to focus on what matters: growing your business.
Want to learn more? Contact our team today to get started.