Are Your Contractors Really Employees? Current and Proposed Rules Explained
Independent contractor rules are tightening at the federal and state levels, and the cost of getting classification wrong keeps going up. For employers, contractors, and freelancers alike, understanding how the IRS, the U.S. Department of Labor (DOL), and states like South Dakota define “independent contractor” versus “employee” is essential to avoiding back taxes, penalties, and legal headaches.
Current Federal Rules in 2026
Worker classification in 2026 is still grounded in federal guidance from both the IRS and the DOL. The core question remains: is the worker truly in business for themselves, or are they functionally an employee under another label?
IRS Common Law Test
The IRS uses a three‑pronged “Common Law Test” that looks at the degree of control and the nature of the relationship:
Behavioral control: Who controls how the work is done? Detailed instructions, required training, and close supervision indicate employee status.
Financial control: Who controls the financial side? Key indicators include whether the worker can realize a profit or loss, whether they have a significant investment in tools and equipment, whether they incur unreimbursed expenses, and how they are paid.
Relationship of the parties: What does the relationship look like on paper and in practice? Written contracts, benefits such as insurance or retirement plans, the expected duration, and whether the work performed is a key part of the business all matter.
If the business has the right to control not only the result, but also how and when the work is performed, the IRS generally treats the worker as an employee under guidance like Publication 15‑A.
DOL Economic Realities Test (FLSA)
Under the Fair Labor Standards Act (FLSA), the DOL focuses on whether a worker is economically dependent on an employer or truly in business for themselves. This “Economic Realities Test” looks at factors such as:
The nature and degree of control over the work
The worker’s opportunity for profit or loss based on managerial skill
The worker’s investment in equipment or materials
Whether the work requires special skill and initiative
The permanence of the relationship
Whether the work is integral to the employer’s business
The DOL’s primary concern is whether a worker is a covered employee entitled to minimum wage, overtime, and other protections.
Proposed and Recently Finalized DOL Rules (2024–2026)
In recent years, the DOL has refined how it applies the Economic Realities Test to independent contractors.
A rule finalized in the mid‑2020s emphasizes that the central inquiry is economic dependence. It highlights two core factors:
The nature and degree of control over the work
The worker’s opportunity for profit or loss
It then considers additional factors such as:
The amount of skill required
The permanence of the relationship
Whether the work is part of an integrated unit of production
The goal is to reduce misclassification by making it more difficult to treat as “contractors” those workers who, in substance, operate like employees under the FLSA.
Need a second set of eyes on your contractor vs employee classifications? Black Hills Accounting can review your current arrangements, highlight red flags, and help you document each relationship under IRS, DOL, and South Dakota rules so you’re ready if anyone asks. Visit: blackhillsaccounting.com or Call: 605-340-9580
IRS Enforcement Focus and Correction Options
While the IRS’s Common Law Test has not dramatically changed, enforcement has intensified.
Increased coordination: The IRS and DOL share information more frequently, increasing the odds that a misclassification issue identified in one arena may surface in the other.
Voluntary Classification Settlement Program (VCSP): This program allows employers to voluntarily reclassify workers as employees for future tax periods. In exchange, they receive partial relief from past federal employment tax liabilities, offering a more manageable on‑ramp to compliance.
For employers who suspect past misclassification, VCSP can be a practical way to reset without facing the full weight of retroactive payroll taxes and penalties.
Don’t wait for a letter from the IRS or Department of Labor to find out something’s wrong. Let Black Hills Accounting help you update contracts, tighten onboarding processes, and align your payroll and bookkeeping with the latest federal and South Dakota tests for independent contractors. Visit: blackhillsaccounting.com or Call: 605-340-9580
State-Level Developments: ABC Tests and Stricter Standards
States add another layer of complexity. Some have adopted stricter tests than the federal government, and a worker can be a contractor under federal rules but an employee under state law.
South Dakota Independent Contractor Rules and Tests
South Dakota’s rules align with federal principles but have important state‑specific nuances, particularly for unemployment insurance, tax, and workers’ compensation.
South Dakota DLR Common Law Approach
The South Dakota Department of Labor and Regulation (DLR) uses a variation of the Common Law Test similar to the IRS, focusing on:
Behavioral control: Does the company have the right to direct how tasks are performed, including instructions, training, and scheduling?
Financial control: Who controls key financial aspects like payment methods, reimbursement of expenses, and the provision of tools or equipment?
Relationship of the parties: Are there contracts, benefits, or indications that the relationship is ongoing and central to the business?
When a business retains significant control over how work is done and integrates the worker into its core operations, the DLR is more likely to see an employment relationship.
South Dakota’s ABC Test for Unemployment Insurance
For unemployment insurance purposes, South Dakota applies a modified ABC Test. A worker is considered an independent contractor only if all of these conditions are met:
A: The worker has been and will continue to be free from control or direction in performing the service, both under the contract and in reality.
B: The service is either outside the usual course of the business or performed outside all the places of business of the hiring entity.
C: The worker is customarily engaged in an independently established trade, occupation, profession, or business of the same nature as the service performed.
If any of these elements fail, the worker is generally treated as an employee for unemployment purposes, which can affect contributions and coverage.
South Dakota Department of Revenue (DOR) Perspective
For tax purposes, the South Dakota Department of Revenue generally follows federal classification. If a worker is treated as an independent contractor for federal tax purposes, that classification typically carries through at the state level.
However, the DOR can perform its own analysis if classification affects state tax liabilities or if there is a dispute. Employers should assume that inconsistent treatment between federal and state filings can attract scrutiny.
Workers’ Compensation Rules in South Dakota
For workers’ compensation, South Dakota also looks at:
Whether the employer has the right to control the details of the work
Whether the worker is engaged in an independent business or occupation
Whether the work is a regular part of the employer’s business
When a worker is closely controlled and performs regular, ongoing tasks central to the business, they are more likely to be treated as an employee for workers’ compensation coverage.
If you hire in South Dakota, you’re juggling federal rules plus state-level Common Law and ABC tests for unemployment and workers’ comp. Black Hills Accounting can walk you through those layers, keep your records audit-ready, and build a practical classification framework tailored to your business. Visit: blackhillsaccounting.com or Call: 605-340-9580
Practical Implications for South Dakota Employers
Misclassifying workers in South Dakota can trigger:
Back unemployment contributions and penalties
Workers’ compensation exposure
State tax assessments, plus federal issues layered on top
Employers should:
Apply both the Common Law and ABC frameworks where relevant
Document the independence of contractors carefully (including contracts, evidence of separate businesses, and proof of multiple clients)
Consult legal and tax professionals when classification is unclear
Monitor updates from the DLR and DOR, as rules and interpretations can evolve
Why This All Matters
Across federal and state levels, the trend is toward closer scrutiny of independent contractor classifications. For employers, this means:
Higher risk if you treat core workers as contractors
Greater need for clean documentation, consistent practices, and periodic audits of contractor relationships
Potential advantages to proactively reclassifying certain workers to avoid larger liabilities later
For contractors and freelancers, stricter rules may limit some “contractor” arrangements but can also expand access to protections when work is essentially employee‑like.
California’s ABC Test
California’s ABC Test (embodied in AB5 and related statutes) presumes that workers are employees unless a hiring entity can prove all of the following:
The worker is free from control and direction in performing the work, both by contract and in practice.
The worker performs work outside the usual course of the hiring entity’s business, or outside all the places of business of the hiring entity.
The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed.
This test is more rigid than the federal IRS and DOL standards, especially when workers perform core revenue‑generating tasks for a business.
Other States
States like New York have proposed or implemented similar ABC‑style frameworks in certain contexts (such as wage and hour or specific industries), leading to a patchwork of rules that multistate employers must navigate carefully.