Worker Classification Risk in Due Diligence

Worker classification

Also known as: employee misclassification, independent contractor risk, 1099 vs W-2 classification

Definition

Worker classification is the determination of whether a worker is an employee or an independent contractor. Misclassification can create unpaid payroll taxes, overtime, benefits and penalties that a buyer may inherit.

Updated November 2026

Worker classification, explained simply

Treating workers as contractors avoids payroll taxes and benefits. If those workers in substance operate as employees, under set hours, company supervision and company equipment, tax and labor authorities can reclassify them and assess back amounts.

Tests differ by authority: the IRS applies a common-law control test, the Department of Labor an economic reality test for wage rules, and some states, such as California, apply a stricter ABC test.

Indicators of employment and of contractor status

Indicators

Where indicators point to employment, the exposure is back payroll taxes, overtime and penalties, plus a higher run-rate cost.

Worked example

Alder Creek pays 12 machine operators as contractors on 1099 forms. They work full-time on company equipment, on company shifts and under a supervisor. Diligence rates the risk of reclassification as high, with estimated exposure for unpaid employer payroll taxes, overtime and penalties of $0.4 million. The buyer requires the workers to be moved onto payroll before closing, adds a specific indemnity and includes the cost of employing them in adjusted EBITDA.

Alder Creek Manufacturing, Inc. is a fictional company. All figures are illustrative.

A note

This page explains general concepts and is not legal or tax advice. Rules vary by jurisdiction and change over time.

Why it matters in a deal

Misclassification creates a past liability and a higher future cost. Both affect price: the first as a debt-like item, the second through lower EBITDA.

Red flags

Contractors doing the same work as employees
Long-term, full-time contractors paid on 1099 forms
Contractors based in states with strict tests

Frequently asked questions

What is worker classification in M&A?

Does the buyer inherit misclassification risk?

In a stock purchase, yes. In an asset purchase the risk is lower but not always zero.

Can misclassification be corrected before the sale?

Yes. Moving workers onto payroll and, where available, using government settlement programs can reduce exposure.