Independent Contractor vs. Employee: Classification Guide

Why Classification Matters

Misclassifying employees as independent contractors can result in:

• Back payment of wages, overtime, and benefits
• Tax penalties and interest
• Liability for workers' compensation and unemployment insurance
• State-level fines and penalties
• Lawsuits from misclassified workers

IRS Common Law Rules

The IRS uses three categories to determine classification:

Behavioral Control

Does the company control what the worker does and how they do it?

• Instructions on when, where, and how to work suggest employee status
• The right to direct and control the work is key - actual exercise of control is not required

Financial Control

Does the company control the business aspects of the worker's activities?

• Investment in equipment and facilities
• Unreimbursed expenses
• Opportunity for profit or loss
• Method of payment
• Availability of services to the market

Relationship of the Parties

How do the company and worker perceive their relationship?

• Written contracts describing the relationship
• Whether the company provides benefits
• Permanency of the relationship
• Extent to which services are integral to the business

Department of Labor Test

The DOL uses an "economic reality" test focused on whether the worker is economically dependent on the employer:

1. Opportunity for profit or loss based on initiative or investment
2. Investments by the worker and the employer
3. Permanence of the work relationship
4. Nature and degree of control
5. Whether the work is integral to the employer's business
6. Skill and initiative

State Tests

Many states use different tests, often stricter than the federal standard. The "ABC test" used in several states presumes a worker is an employee unless the employer proves:

• (A) The worker is free from control and direction
• (B) The work is outside the usual course of the hiring entity's business
• (C) The worker has an independently established trade or business

Best Practices

1. Analyze each engagement individually - no single factor is determinative
2. Document the basis for your classification decision
3. Use written agreements that accurately reflect the relationship
4. Audit your contractor relationships periodically
5. Consult legal counsel for borderline cases
6. When in doubt, err on the side of classifying as an employee