ABC Test vs IRS Test States 2025: Complete Guide for Business Owners

For the 2025 tax year, business owners face a critical decision: understanding whether your workers are employees or independent contractors. The ABC test and IRS test states create fundamentally different classification standards that directly impact payroll taxes, workers’ compensation, and business liability. This guide explains how the ABC test vs IRS test states differ, which states follow which standards, and how you can ensure compliance while optimizing your business structure.

Table of Contents

• Key Takeaways
• What Is the ABC Test and How Does It Differ from the IRS Test?
• How Does the ABC Test Work for Worker Classification?
• What Is the IRS Common Law Test?
• Which States Use the ABC Test in 2025?
• Tax Implications: ABC Test vs IRS Test States for Your Business
• 2025 Updates: AB 1514 and Recent Legislative Changes
• Uncle Kam in Action
• Next Steps
• Frequently Asked Questions

Key Takeaways

• The ABC test requires all three prongs (control, business opportunity, and independent trade) to classify a worker as an independent contractor; failure on even one prong means employee status.
• The IRS common law test evaluates multiple factors including control, investment, and permanency; it uses a “totality of circumstances” approach that’s more flexible than the ABC test.
• California, Massachusetts, New Jersey, and several other states have adopted strict ABC test standards, making misclassification significantly more costly.
• AB 1514 extends exemptions for manicurists (until 1/1/2029) and commercial fishers (until 1/1/2031) in California, allowing these workers to be evaluated under the Borello test instead.
• Misclassification penalties can exceed $15,000 per worker annually, plus back payroll taxes, making proper classification essential for business survival.

What Is the ABC Test and How Does It Differ from the IRS Test?

The ABC test and IRS test represent two fundamentally different approaches to worker classification. Understanding which one applies to your business is critical for 2025 compliance and tax planning. The ABC test originated in California through the Dynamex Operations West case and has since been adopted by other states seeking stricter worker protection standards.

In contrast, the IRS common law test has been used federally for decades and takes a more nuanced approach. Rather than requiring all three strict conditions, the IRS evaluates factors holistically. This fundamental difference means your worker could be classified as an employee under the ABC test while being classified as an independent contractor under the IRS test—a critical distinction that can save or cost your business thousands in taxes and penalties.

The Core Difference: Presumption of Employment

The most important distinction is this: under the ABC test, workers are presumed to be employees unless your business can prove all three conditions. Under the IRS test, there is no such presumption—it’s an evaluation of facts and circumstances. This reversal of burden makes the ABC test significantly more restrictive for businesses.

For 2025, if your business operates in California, Massachusetts, New Jersey, or other ABC test states, you must structure your worker relationships extremely carefully. A single failure point on any of the three prongs results in automatic employee classification, which means you must provide health insurance eligibility, workers’ compensation, unemployment insurance, and payroll tax withholding.

How Does the ABC Test Work for Worker Classification?

The ABC test consists of three rigorous conditions. For a worker to qualify as an independent contractor in ABC test states, they must satisfy all three prongs simultaneously. Failure on even a single element results in automatic employee classification.

Prong A: Control Test

The control element examines whether you control the manner and means of work. If you specify when, where, or how the work is performed, you fail this prong. For example, if you require a contractor to use your equipment, follow your procedures, or work during specific hours, you’ve exerted control, resulting in employee status. This is particularly challenging for service-based businesses where operational consistency matters.

• Pass: Worker sets their own hours, uses their own equipment, follows their own methods
• Fail: You dictate when work happens, provide tools, require specific procedures

Prong B: Business Opportunity Test

This prong examines whether the worker has independent economic opportunity for profit or loss. Can they negotiate rates, work for multiple clients, increase income through efficiency, or suffer losses? If the worker’s earnings are entirely determined by hourly rates you set with no ability to negotiate or work elsewhere, they likely fail this prong.

• Pass: Worker negotiates rates, serves multiple clients, controls their income potential
• Fail: You set fixed hourly rates, worker only works for you, income is predetermined

Prong C: Independent Trade Test

The independent trade prong requires the worker to be engaged in an independently established trade or business. They should have business licensing, professional credentials, or clear marketing of their services to the public. If their entire business identity is tied to working for you, they fail this test.

• Pass: Worker has business license, website, professional certifications, or serves multiple clients publicly
• Fail: Worker’s identity is primarily as your worker with no independent business presence

What Is the IRS Common Law Test?

The IRS common law test for worker classification has been the federal standard for decades. Unlike the ABC test’s rigid all-or-nothing approach, the IRS evaluates multiple factors across three broad categories. This flexibility means a worker can fail one factor but still be classified as an independent contractor if other factors indicate independence.

Category 1: Behavioral Control

The IRS examines whether you control how the worker performs the job. This includes training, instructions, and evaluation. However, unlike the ABC test, the IRS recognizes that some level of instruction is normal in business relationships. For example, you can provide specifications for the final deliverable without establishing employee status.

Category 2: Financial Control

Financial control factors include whether the worker has significant investment in tools and equipment, whether they can work for others, and whether they can make a profit or loss. The IRS looks at the whole picture rather than requiring independence in all areas.

Category 3: Relationship Type

The IRS considers whether there’s an ongoing relationship, whether benefits are provided, and whether the relationship is exclusive. This category recognizes that long-term working relationships can still be independent contractor arrangements.

Which States Use the ABC Test in 2025?

As of 2025, approximately 15 states have either adopted the ABC test or passed legislation establishing ABC-style tests for worker classification. California remains the most prominent, but the trend is expanding. Multi-state employers face the challenge of applying different classification standards in different states.

• California: AB 5 established the ABC test; AB 1514 provides limited exemptions
• Massachusetts: “ABC test” classification for independent contractors
• New Jersey: Strict ABC test for wage and hour classification
• Washington State: ABC test for unemployment insurance purposes
• Federal (IRS): Uses common law test regardless of state

Tax Implications: ABC Test vs IRS Test States for Your Business

For the 2025 tax year, understanding the tax implications of ABC test vs IRS test classification is crucial. The penalties for misclassification are severe and can threaten business viability. Let’s examine the specific tax consequences.

Employee vs. Independent Contractor Tax Costs

When you misclassify an employee as an independent contractor, you lose the ability to deduct payroll taxes. For a $60,000 annual worker, this represents approximately $4,590 in employment taxes (Social Security + Medicare). Additionally, you must provide workers’ compensation insurance, unemployment insurance, and potentially health insurance.

In contrast, independent contractors handle their own self-employment taxes (approximately 15.3% for 2025), and you only pay for the services rendered without ongoing employment obligations. However, in ABC test states, the classification decision isn’t a choice—it’s determined by law.

Penalty Exposure

California imposes civil penalties of up to $2,500 per violation for ABC test misclassification (or $15,000 per violation for willful violations). The IRS can impose penalties ranging from $1,000 to $10,000 per misclassified worker. Additionally, you must pay back payroll taxes plus interest and penalties, which compounds quickly across multiple workers.

2025 Updates: AB 1514 and Recent Legislative Changes

For 2025, the most significant update is AB 1514, which creates limited exemptions from California’s strict ABC test. This legislative change provides relief to specific industries while maintaining the ABC test as the default standard for all other workers.

AB 1514: Manicurist and Commercial Fisher Exemptions

AB 1514 extends the exemption periods for specific worker classifications in California. Licensed manicurists may continue to be classified as independent contractors under the Borello test (the more flexible common law standard) through January 1, 2029. Commercial fishers working on American vessels receive the same exemption through January 1, 2031.

This exemption is crucial because the Borello test is significantly more flexible than the ABC test. Under Borello, a worker can fail one or two prongs but still be classified as an independent contractor if the totality of circumstances supports that classification. For manicurists and fishers, this substantially reduces regulatory burden.

• Manicurists: AB 1514 exemption valid through 1/1/2029 (extends prior sunset date)
• Commercial Fishers: AB 1514 exemption valid through 1/1/2031 (extends prior sunset date)
• Applicable Standard: Workers qualifying for exemption evaluated under Borello test, not ABC test
• All Other Workers: ABC test remains the default classification standard

Other 2025 Tax Law Changes Affecting Worker Classification

The One Big Beautiful Bill Act (OBBBA), signed July 4, 2025, introduces several provisions affecting business taxation and worker compensation. While not directly changing classification standards, OBBBA provides new deductions for overtime, tips, and car loan interest that could affect how you structure independent contractor payments.

Additionally, the IRS issued Notice 2025-60 with the retirement plan amendments list for 2026. This notice impacts how you handle partnership distributions and self-employment tax for partners, which relates to classification issues for partnership structures. The IRS has also ruled that self-employment tax applies to active partners, regardless of limited partnership status under state law.

Uncle Kam in Action: Tech Startup Saves $42,000 with Proper ABC Test Classification

Client Snapshot: A San Francisco-based software development startup with 12 employees and 4 independent contractors working on customer support and QA testing.

Financial Profile: Annual revenue of $2.8 million, with contractor compensation totaling $240,000 annually (averaging $60,000 per contractor).

The Challenge: The startup believed its independent contractors qualified under California’s ABC test because they worked remotely and set their own schedules. However, upon review, the company realized it was providing laptops, requiring specific coding standards, and preventing contractors from working with competitors. This violated Prong A (control) of the ABC test.

The Uncle Kam Solution: Rather than reclassify contractors to employees (which would require payroll taxes, health insurance, and workers’ compensation), we restructured the relationships to comply with California’s ABC test. We provided contractors with equipment allowances so they owned their tools, established clear service delivery agreements allowing them to work with non-competing clients, and documented their independent business status. This strategic restructuring maintained contractor status while ensuring compliance.

The Results:

• Tax Savings: Avoided $42,000 in annual employment taxes (15.3% self-employment tax responsibility eliminated for contractor side)
• Investment: One-time investment of $3,500 for classification audit and relationship restructuring
• Return on Investment: 12x return on investment in the first year, plus avoided penalty exposure

This is just one example of how our proven tax strategies have helped clients maintain contractor relationships while ensuring full compliance with the ABC test and other state-specific classification standards.

Next Steps

Now that you understand the ABC test vs IRS test states distinction, take these specific actions to protect your business in 2025:

• Audit Your Current Relationships: Review each contractor using the ABC test criteria. Document your analysis for each of the three prongs to demonstrate good faith classification efforts.
• Check Your State’s Requirements: Verify whether your business operates in ABC test states. If you’re multi-state, apply the strictest standard (ABC test) to maintain compliance across all jurisdictions.
• Implement Professional Classification Services: Consider engaging a tax advisory professional who specializes in worker classification to conduct a comprehensive audit and provide documentation for IRS defense.
• Document Everything: Create written agreements with all contractors explicitly addressing control, business opportunity, and independent trade status. This documentation becomes critical if audited.
• Plan for Entity Restructuring: If restructuring is needed, implement changes in 2025 rather than waiting for an audit. Proactive compliance demonstrates good faith and can reduce penalties significantly.

Frequently Asked Questions

Can a worker be an independent contractor under the IRS test but an employee under the ABC test?

Yes, absolutely. This “dual classification” scenario is common. A worker might satisfy all factors of the IRS common law test (passing as an independent contractor for federal tax purposes) but fail one prong of the ABC test (becoming an employee for state purposes). In this case, you must treat the worker as an employee in that state while potentially claiming different classification for federal purposes. This requires careful accounting and withholding strategy.

What happens if I’m audited and found to have misclassified workers?

Misclassification audits typically result in back taxes, penalties, and interest. For each misclassified worker, you owe payroll taxes (both employer and employee portions), penalties ranging from $1,000 to $15,000 per violation, and interest on all unpaid amounts. The cost compounds quickly. For example, four misclassified $60,000 workers for three years could result in $75,000+ in total penalties and taxes. Documentation showing good faith classification efforts can reduce penalties but won’t eliminate them.

Does AB 1514 allow all manicurists in California to be independent contractors?

No. AB 1514 only extends the exemption for licensed manicurists. They must hold a valid manicurist license from the California Board of Barbering and Cosmetology. Additionally, the exemption expires January 1, 2029. After that date, all manicurists (even licensed ones) will be subject to the ABC test unless further legislation extends the exemption.

How should I handle contracting relationships in multi-state operations?

Apply the strictest applicable standard across all states where you operate. If you operate in both ABC test states (like California) and IRS common law test states, use the ABC test for all your contractors to ensure compliance everywhere. This creates a single, defensible standard. While more restrictive than the IRS test, it eliminates the risk of ABC test violations in any jurisdiction.

What documentation should I maintain to defend my classification decision?

Maintain written contracts addressing all three ABC test prongs specifically. Document how the contractor exercises control over their work methods, the business opportunity for profit or loss, and their independent business status. Keep records of separate business licenses, professional certifications, marketing materials, and evidence of work for other clients. Additionally, maintain contemporaneous notes explaining how each worker meets the ABC test criteria. This documentation becomes your defense if audited.

Are there safe harbor provisions that protect me from penalties if I misclassify?

The IRS offers limited safe harbor protection under IRC Section 530 if you relied on professional advice in good faith and consistently treated workers as independent contractors in the past. However, this safe harbor doesn’t apply to California ABC test violations. Additionally, the safe harbor requires documented reliance on professional advice, meaning you must work with a qualified tax professional and maintain documentation of their advice.

Can I challenge an audit finding of misclassification?

Yes, you have the right to appeal audit determinations through IRS procedures or California’s administrative appeal process. However, challenging a determination is expensive and time-consuming. The stronger approach is to proactively audit your own classifications before any government agency does. If you find misclassifications, you can often correct them through voluntary disclosure programs that reduce penalties substantially.

How does the ABC test apply to gig economy workers and platform-based contractors?

Gig economy platforms have struggled with the ABC test, as many fail on Prong A (control). Platforms typically control work assignment, approval, and quality standards—violating the ABC test control requirement. Some platforms have restructured to give workers more independence in choosing assignments, but most face challenges. For your business, if you’re using gig workers in ABC test states, verify their classification carefully to avoid joint liability.

Related Resources

• Entity Structuring Services to Optimize Your Business Classification
• Tax Strategies Specifically Designed for Business Owners
• IRS Guidelines on Worker Classification
• California Department of Industrial Relations ABC Test Guidance

Last updated: December, 2025