How to Seamlessly Convert Contractors to Employees

At some point, you might need to convert an independent contractor to an employee.

You might have worked with a contractor several times, but now you want to hire them as an employee. For example, you might have used an independent contractor to periodically assist with your business’s marketing, but now you want to hire them as an employee who permanently works for you.

Or, you might have misclassified an employee and need to reclassify them under the 2024 DOL contractor rule. You labeled a worker as a contractor when you should have labeled them as an employee. If this happens, you need to convert them immediately.

Learn how to convert independent contractors to employees below in six clear steps, plus get a checklist and FAQs.

Converting from contractor to employee

Use the following steps to convert your contractor to an employee.

1. Verify worker classification

First, you need to make sure that the contractor really should be an employee. Constantly switching a worker’s classification might give the IRS incentive to audit you.

To determine if a worker is a contractor or employee, use the Department of Labor’s six-part test and the IRS three-prong test. If you’re still not sure how to classify a worker, you can contact the Department of Labor and/or file Form SS-8 with the IRS.

With contractors, you use the 1099-NEC form to report their wages. You do not withhold or contribute taxes on their wages. Instead, the contractors pay the taxes themselves.

With employees, you use Form W-2 to report their wages. You must withhold and contribute taxes on their wages.

Switching from contractor to employee means switching from Form 1099 to Form W-2.

Quick check before switching:

• Does your business control how, when, and where the work is done (not just the result)?
• Is the work integral to your core business, performed on a continuing basis?
• Does the worker have limited opportunity for profit or loss and minimal investment?
• Do you set schedules, provide tools/equipment, or restrict outside work? If “yes” to several, employment status is likely. Some states (e.g., CA, MA, NJ) use stricter “ABC” tests, so consult state rules.

Contractor vs. employee: Quick comparison

• Taxes: Contractors have no withholdings; you issue 1099-NEC. Employees require that you withhold income and FICA; you issue W-2.
• Benefits: Not required for contractors; employees may be eligible per your policies (e.g., PTO, health).
• Payroll: Contractors you pay per contract; Employees you run payroll on a schedule with tax deposits and filings.
• Compliance risk: Misclassification can trigger back taxes, penalties, and interest.

2. Notify the worker

As soon as you decide to convert the contractor to an employee, notify the worker. Preferably, tell the worker in writing. A written memo is easier to track and document than a verbal message.

Document the date you notify the worker. If you mail the notification, obtain proof of mailing.

What to include in the notice/offer letter:

• Start date as an employee and position title
• Pay rate and pay frequency; exempt vs. nonexempt status
• Eligibility and waiting periods for benefits (e.g., health, PTO accrual)
• Work schedule, supervisor, and timekeeping expectations
• Any changes to equipment, expense reimbursement, or location

3. Gather employee information

You need to start an employee file and collect employment information to fill it.

For example, have the worker fill out Form W-4, Employee’s Withholding Certificate. You and the employee should also fill out Form I-9, which verifies their eligibility to work in the U.S.

You should also add information about the employee’s pay to their file. This will include items like their rate of pay, whether they are hourly or salary, whether they are exempt or nonexempt, and their pay frequency.

Also complete:

• State withholding and local tax forms (where applicable)
• Direct deposit authorization (if used)
• Employee handbook and policy acknowledgments
• New hire reporting to your state (generally within 20 days; check your state’s deadline)
• E-Verify, if required for your business or state

4. Adjust payroll

You need to add your new employee to your payroll and time and attendance software.

Add the employee to your payroll so you can pay them properly and on time. You should enter their pay rate and pay frequency. If the employee should receive overtime wages, make sure you mark them as nonexempt.

Make sure the employee has access to your time clock, if you use one.

Don’t forget to:

• Enable federal, state, and local tax withholding and employer taxes (FICA, FUTA/SUTA).
• Set overtime rules and meal/rest break policies per federal and state laws.
• Configure PTO accruals and benefit deductions (when eligible).
• Schedule payroll tax deposits and filings to avoid penalties.

5. Treat the employee equally

You should treat the converted employee the same as any other employee.

If you give benefits to the rest of your employees, you should also offer benefits to this new employee. If you offer paid time off, this employee should receive it as well. Of course, you should follow your established policies.

Apply policies consistently (pay, scheduling, benefits eligibility, leave) to avoid discrimination claims. If you have waiting periods for benefits, document them clearly in the offer letter and handbook.

6. Distribute Form W-2

You must give employees a Form W-2 after the end of each year. Form W-2 reports their wages for the year, along with how much of each tax you withheld from their wages.

Send the form to the employee by January 31. You must also send this form to the Social Security Administration.

Conversion timeline and checklist

• Before the switch: Confirm classification (DOL/IRS tests). Decide start date and compensation; draft offer letter.
• Day 1: Collect W-4; start I-9 (complete by Day 3). Provide handbook and policy acknowledgments.
• First week: Add to payroll and timekeeping; set tax withholdings and employer tax accounts; report new hire to the state.
• First pay run: Verify hours (if nonexempt), benefits deductions (if applicable), and correct net pay.
• Year-end: Provide Form W-2 by January 31; retain I-9 and payroll records per retention rules.

Things to watch out for

If a contractor should really be an employee, you must convert them.

Converting from contractor to employee might cause the IRS to flag your business for an audit. If you’ve done nothing wrong, you have nothing to worry about. However, if you misclassified a worker as a contractor when they should have been an employee, there may be consequences.

Because you don’t pay taxes on contractor wages, you may owe taxes on the wages previously paid to the worker. You might also have to pay interest and penalties.

If you can provide a reasonable basis for treating the employee as a contractor, you might be able to avoid paying employment taxes. Publication 1976, Section 530 has more information.

You might also qualify to use the Voluntary Classification Settlement Program (VCSP). This program lets you reclassify workers with partial tax relief.

More compliance notes:

• States may apply their own tests (e.g., ABC test) and penalties—review your state’s rules.
• VCSP can reduce past federal employment tax liability if you voluntarily reclassify and meet eligibility criteria.
• Maintain documentation (offer letter, W-4, I-9, policy acknowledgments, timesheets) to substantiate compliance.

FAQs: Converting contractors to employees

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This article has been updated from its original publication date of June 25, 2018.

This is not intended as legal advice; for more information, please click here.