W-2 Employees vs. 1099 Contractors: What Colorado employers Must Know

One of the most consequential decisions a Colorado employer makes is whether a worker is an employee (W-2) or an independent contractor (1099). Get it wrong, and you face back taxes, penalties, and potential lawsuits — not just from the IRS, but from Colorado's aggressive enforcement agencies. Colorado applies a stricter test than the federal government, meaning workers who might qualify as contractors under IRS rules could still be classified as employees under Colorado law. This guide explains both tests, the penalties for misclassification, and how to make the right call for your business.

Why Classification Matters

The financial difference between a W-2 employee and a 1099 contractor is substantial. When you hire a W-2 employee, you are responsible for:

• Payroll taxes: Social Security (6.2%), Medicare (1.45%), FUTA (0.6%), Colorado SUI (1.5%-6.2%), and ETT (0.1%) — all paid by you as the employer
• Withholding: Federal income tax, Colorado PIT, and SUI (1.1%) — withheld from the employee's pay and remitted on their behalf
• Benefits and protections: Workers' compensation insurance, unemployment insurance eligibility, overtime pay, meal and rest breaks, paid sick leave, and other Colorado labor protections

When you engage a 1099 independent contractor, you pay none of those taxes, provide none of those benefits, and have far fewer legal obligations. The contractor handles their own self-employment taxes (15.3% FICA), buys their own insurance, and has no claim to overtime or meal breaks.

It is easy to see why some businesses are tempted to classify workers as 1099 contractors when they are really employees. The cost savings can be 20-30% or more per worker. But the penalties for getting it wrong — especially in Colorado — can far exceed those savings.

The Federal IRS Test: Three Categories

The IRS uses a common-law test that evaluates the working relationship based on three broad categories. There is no single factor that determines the outcome — the IRS looks at the totality of the relationship:

1. Behavioral Control

Does the business control how the work is done? Key questions include:

• Does the business provide instructions on when, where, and how to do the work?
• Does the business provide training?
• Does the business dictate the sequence of work or require status reports?

If the business controls or has the right to control these details, the worker is more likely an employee.

2. Financial Control

Does the worker have financial independence? Key questions include:

• Does the worker have a significant investment in their own equipment or tools?
• Does the worker have unreimbursed business expenses?
• Does the worker market their services to other businesses?
• Is the worker paid by the project, or by the hour/salary?
• Can the worker realize a profit or loss from the work?

If the worker has financial independence and risk, they look more like a contractor.

3. Relationship Type

What is the nature of the relationship? Key questions include:

• Is there a written contract? (A contract alone is not determinative, but it is a factor.)
• Does the business provide employee-type benefits (insurance, retirement, paid leave)?
• Is the relationship expected to be permanent or indefinite, or is it for a specific project?
• Is the work performed a key aspect of the business's regular operations?

The IRS test is subjective and fact-specific. There is no bright-line rule, and reasonable people can disagree on borderline cases. If you are unsure, you can file IRS Form SS-8 to request a determination, though this process can take six months or more.

Colorado's ABC Test: The Stricter Standard

Colorado does not use the IRS common-law test for most purposes. Instead, Colorado applies the ABC test, which was established by the Colorado Supreme Court in the landmark 2018 case Dynamex Operations West, Inc. v. Superior Court.

Under the ABC test, a worker is presumed to be an employee unless the hiring entity can prove all three of the following:

The ABC test is significantly stricter than the IRS test. The most impactful prong is Prong B: if the work a person does is part of your core business, they are almost certainly an employee under Colorado law — regardless of how much freedom they have or whether they have their own business.

Example: A software company hires a freelance software developer to build features for the company's product. Under the IRS test, this person might qualify as a contractor if they use their own equipment, set their own hours, and serve multiple clients. Under Colorado's ABC test, the company would likely fail Prong B, because software development is the company's usual course of business. The worker would be classified as an employee.

AB5: Codifying the ABC Test into Law

In September 2019, Colorado Governor Gavin Newsom signed Assembly Bill 5 (AB5), which codified the Dynamex ABC test into Colorado statute, effective January 1, 2020. AB5 made the ABC test the default standard for determining worker classification under the Colorado Labor Code, the Unemployment Insurance Code, and IWC Wage Orders.

AB5 was one of the most significant changes to Colorado employment law in decades. It effectively reclassified hundreds of thousands of workers across the state from independent contractors to employees, with profound implications for industries that relied heavily on contractor models — including ride-sharing, trucking, freelance journalism, and the gig economy broadly.

AB5 Exemptions: Who Is Excluded

AB5 does include exemptions for certain occupations and business relationships. Workers in these categories are evaluated under the older, more flexible Borello test (similar to the IRS common-law test) rather than the ABC test. Key exemptions include:

• Licensed professionals: Doctors, dentists, podiatrists, psychologists, veterinarians, lawyers, architects, engineers, accountants, insurance agents, securities broker-dealers, and others
• Business-to-business relationships: Where the contractor has a business license, maintains a business location, has the ability to set their own rates, and can serve other clients
• Referral agencies: Under specific conditions
• Certain creative professionals: Fine artists, grant writers, photographers (with limitations), freelance writers (subject to a submission cap that was later modified by AB 2257)
• Real estate agents and repossession agents
• Certain motor club services

In 2020, Colorado voters passed Proposition 22, which created a specific exemption for app-based transportation and delivery companies (Uber, Lyft, DoorDash, etc.), though this proposition has faced ongoing legal challenges.

Misclassification Penalties

Misclassifying employees as independent contractors can result in severe penalties from multiple agencies at both the federal and state level:

Federal (IRS) Penalties

• Back employment taxes: You owe the employer's share of FICA (7.65%) plus FUTA on all misclassified wages
• Failure to withhold: 1.5% of wages for income tax not withheld, plus 20% of the employee's share of FICA not withheld
• Failure to file W-2s: $60 to $310 per form, depending on how late
• Penalties and interest on all back taxes owed
• If willful: Criminal penalties including fines up to $1,000 per worker and imprisonment

Colorado Penalties

• Back payroll taxes: Unpaid SUI, ETT, SUI, and PIT withholding for all affected periods
• CO UI penalties: 15% penalty on unpaid taxes, plus interest
• Labor Code penalties: Between $5,000 and $15,000 per violation for willful misclassification, and $10,000 to $25,000 per violation for a pattern or practice of willful misclassification
• Back wages and benefits: Misclassified workers can sue for unpaid overtime, missed meal and rest breaks, unreimbursed business expenses, paid sick leave, and other benefits they were denied
• Waiting time penalties: Up to 30 days of wages for each affected worker
• PAGA claims: Colorado's Private Attorneys General Act allows workers to bring representative actions on behalf of all aggrieved employees, with penalties of $100 per employee per pay period for initial violations and $200 per employee per pay period for subsequent violations

When Each Classification Makes Sense

A Worker Should Be a W-2 Employee When:

• You control when, where, and how they do the work
• The work they do is part of your regular business operations
• They work only (or primarily) for you
• You provide the tools, equipment, or workspace
• The relationship is ongoing and indefinite
• They are integrated into your team and operations

A Worker May Be a 1099 Contractor When:

• They have their own established business, with a business license and business presence
• They set their own schedule, methods, and rates
• The work they do is outside your core business (e.g., you hire an electrician to rewire your office — you are not an electrical company)
• They serve multiple clients
• They provide their own tools and equipment
• The engagement is project-based with a defined scope and end date

When in doubt in Colorado, the safer assumption is that the worker is an employee. The cost of providing employee benefits and paying payroll taxes is almost always less than the cost of a misclassification audit or lawsuit.

Protecting Your Business

If you do engage independent contractors, take these steps to support the classification:

• Use a written independent contractor agreement that clearly defines the scope, deliverables, payment terms, and relationship
• Collect a W-9 from each contractor before the first payment
• Issue 1099-NEC forms to any contractor you pay $600 or more during the year (due to the contractor by January 31, and to the IRS by January 31)
• Do not provide training, set schedules, or dictate methods — if you need that level of control, hire an employee
• Document the business-to-business nature of the relationship: the contractor's business license, website, other clients, insurance, etc.
• Consult an employment attorney before classifying any worker as a contractor, especially in Colorado

Remember: a contract that says "independent contractor" is not enough. Both the IRS and Colorado look at the reality of the working relationship, not what the paperwork says. If it walks like an employee and quacks like an employee, it is an employee — no matter what the contract calls it.