Worker misclassification for staffing agencies: which test applies, and why 1099 rarely works

A staffing agency's core business is supplying labor, and that fact works against classifying the people it places as independent contractors. Under an ABC-style state test, doing work inside the hiring entity's usual course of business fails the test by itself; under the federal common law and economic reality tests, the agency's control over who works where, when, and for how much still points toward employee status in most placements. Most workers a staffing agency places belong on a W-2, not a 1099, and getting this wrong exposes the agency to the client, the IRS, the Department of Labor and the state, separately.

Why staffing agencies carry more exposure than a typical employer

A software company that occasionally hires a freelance designer is testing a straightforward question: is this one person an employee or a contractor? A staffing agency is testing that question at the scale of its whole business model, for every worker it places, and the answer tends to come out the same way for a structural reason: supplying people to do work for a client is the staffing agency's business, so the workers it supplies are rarely "outside its usual course of business" or in "an independently established" trade of their own, two of the tests that several states use to allow contractor status. The people most staffing agencies place, temp, temp-to-hire and contract workers, are typically W-2 employees of the agency for exactly this reason. See the contractor onboarding checklist for how that plays out in paperwork.

Which test applies depends on which law is asking

A worker can pass one of these tests and fail another. Treating "the IRS would call this person a contractor" as the end of the analysis is a common and costly mistake, because it leaves the FLSA, state wage law, unemployment insurance and workers' compensation questions unanswered.

The IRS common-law test

The IRS's independent contractor page states the general rule plainly: a worker is an independent contractor if the business has the right to control or direct only the result of the work, not what will be done and how it will be done. Evidence of control falls into three categories, drawn from the older 20-factor analysis in Revenue Ruling 87-41:

• Behavioral control: instructions given, training provided, and how closely the work is supervised.
• Financial control: who bears the investment and the risk of profit or loss, how the worker is paid, and whether the worker can offer services to the relevant market generally.
• Relationship of the parties: written contracts, benefits, permanency of the relationship, and whether the work performed is a key part of the business.

For a staffing placement, the financial-control and relationship factors are usually the hardest to satisfy: the agency, not the worker, sets the bill rate and pay rate, assigns the client, and the placement is often ongoing rather than a single deliverable. A business or worker that genuinely cannot tell can file Form SS-8 and ask the IRS to make the determination; there is no fee, but the IRS does not rule on hypothetical arrangements.

The federal wage-and-hour test, and the rule that is currently in flux

Under the Fair Labor Standards Act, the Department of Labor uses an economic reality test asking whether a worker is economically dependent on the employer. As of September 2026, the department's own enforcement staff apply the seven non-exclusive factors in Fact Sheet #13 (opportunity for profit or loss, investment, permanency, control, skill, integral nature of the work, and independent business organization), informed by the reinstated Opinion Letter FLSA2019-6, rather than the six-factor rule the department published in January 2024. That 2024 rule technically remains in effect and is still cited in private FLSA lawsuits, but the department announced in May 2025 that its own investigators would not use it. A new proposed rule was published for comment in February 2026 (RIN 1235-AA46); as of September 2026 it had not been finalized. Check the department's rulemaking page before relying on any summary of the current standard, including this one.

State ABC tests: why California is the strictest example

Several states apply an ABC test to some or all worker-classification questions, under which a worker is a contractor only if all three of the following are true. California's version, codified at Labor Code § 2775 following AB 5, is the one most staffing agencies run into first because California enforces it broadly:

• A. Control: the worker is free from the hiring entity's control and direction in connection with the work, both under contract and in fact.
• B. Outside the usual course of business: the worker performs work outside the usual course of the hiring entity's business.
• C. Independently established trade: the worker is customarily engaged in an independently established trade, occupation or business of the same nature as the work performed.

Prong B is where a staffing placement typically fails: if the agency's business is supplying workers to do a job, and the worker is doing that job, the work is not outside the agency's usual course of business. California's statute lists specific exemptions, mostly for licensed professionals and certain business-to-business relationships, none of which describe a standard temp or contract placement. Other states apply an ABC test to narrower questions, most often unemployment insurance, rather than to every wage law question; check the specific state agency rather than assuming California's scope carries over.

Patterns that create liability without anyone intending it

What misclassification actually costs

Exposure stacks across agencies rather than replacing itself:

• IRS: unpaid employment taxes, plus, if the agency intentionally disregarded its withholding duty, full liability rather than the reduced rates in Internal Revenue Code § 3509, which otherwise can limit income tax withholding liability to 1.5% of wages paid (3% if required 1099s were not filed), subject to conditions.
• Section 530 relief exists but narrowed. An employer with a reasonable basis for treating workers as contractors, applied consistently and reported on 1099s, can seek relief from retroactive federal tax liability under Section 530 of the Revenue Act of 1978. The IRS's 2025 guidance, Rev. Proc. 2025-3 and Rev. Proc. 2025-10, tightened what counts as a reasonable basis, so do not treat it as a routine fallback.
• DOL/FLSA: back wages for unpaid overtime and minimum wage, liquidated damages, and civil penalties for repeat or willful violations.
• States: back unemployment insurance contributions, workers' compensation exposure if an uninsured "contractor" is hurt on the job, and, in states with an ABC test, separate state wage-and-hour liability.

A self-audit checklist for staffing agencies

1. List every worker currently paid on a 1099 through your agency, not through the client.
2. For each one, ask who controls the schedule, the assignment and the pay rate. If the answer is the agency, that points toward employee status under every federal test.
3. Ask whether the work is the agency's core business. Supplying labor to do the job the worker is doing almost always is, which is the ABC test's hardest prong to clear.
4. Check how long the placement has run and whether it is ongoing rather than project-based. Permanency cuts against contractor status in both the IRS and DOL analyses.
5. Confirm the worker is not economically dependent on your agency alone. A worker who only ever works assignments from one staffing agency looks far less independent than one running a business that serves several clients directly.
6. Do not rely on a signed agreement or a PEO relationship to settle the question. Test the actual facts against the tests above.
7. When genuinely unsure, use Form SS-8 or counsel before the relationship starts, not after a state audit begins.

For the paperwork side of getting a placement right once it is classified, see the contractor onboarding checklist. For how markup and burden rate change between a W-2 temp placement and a true 1099 engagement, see how to calculate staffing markup. For the separate question of whether your agency needs a state license to operate, see employment agency license requirements.