The consequences of misclassifying workers can be costly. If you misclassify an employee as an independent contractor, for example, you may be liable for back taxes (including the employee’s shares of unpaid payroll and income taxes), plus penalties and interest. And, as discussed below, there may be serious nontax consequences as well.

Why does it matter?

Businesses must withhold federal and state income taxes, Social Security taxes, and Medicare taxes from the wages they pay employees and deposit those taxes with the IRS or state tax authorities. They’re also required to pay the employer’s portion of Social Security and Medicare taxes, and to pay federal and state unemployment taxes. Generally, none of these obligations apply to independent contractors.

What happens if you misclassify an employee as an independent contractor? Not only will you be liable for the employer’s portion of payroll taxes that you should have paid (plus penalties and interest), but you also may be on the hook for the employee’s portion of income and payroll taxes.

There may be significant nontax consequences as well. For example, when classified as an employee, the worker may be entitled to minimum wages and other employee benefits. And you may need to furnish workers’ compensation insurance and make state disability insurance contributions.

How do you decide?

To decide whether workers are employees or independent contractors for federal tax purposes, familiarize yourself with the factors the IRS considers in making that determination. Many of these factors go to the degree of control the business exerts over the worker and the degree of independence the worker enjoys. No single factor is determinative, so it’s important to weigh all of them.

The IRS examines factors in three categories:

1. Behavioral control. Does the company control or have the right to control what the worker does and how the worker does it? Generally, the more control the company has, the more likely a worker is an employee. Relevant factors include the extent to which the company provides instruction and training.
2. Financial control. Does the company control the business aspects of the worker’s job, such as how the worker is paid, whether expenses are reimbursed, and who provides tools and supplies? A worker is more likely to be considered an independent contractor if, for example, he or she has an opportunity for profit or loss, makes his or her services available to other businesses, or is paid a flat fee rather than an hourly wage.
3. Relationship of the parties. Workers are more likely employees if the company provides them with employee benefits, they’re hired indefinitely (rather than for a specific time period or project), and they provide services that are a key aspect of the business.

Note that entering a contract with a worker that designates him or her an independent contractor doesn’t make it so. However, it may be a relevant piece of evidence in determining the parties’ relationship.

Important: Many businesses mistakenly believe that all remote workers are independent contractors. The ability to work remotely may demonstrate a worker’s independence. But a remote worker may still be considered an employee if the business controls the details of the work that’s done and how it’s performed.

Gaining peace of mind

Classifying workers as independent contractors can generate significant cost savings. But given the potentially harsh consequences of misclassification, it’s critical to have a reasonable basis for your classification. If you do, and you meet certain other requirements, you may be entitled to relief from penalties and from having to pay the worker’s employment taxes.

What can you do if, after weighing the factors, you’re still uncertain whether a worker or group of workers are employees or independent contractors? Consider asking the IRS to weigh in by filing Form SS-8, “Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.” Or ask your tax advisor to explain the rules in more detail, based on his or her experience working with companies in similar situations, to help you make an informed decision.

Beyond federal taxes

Even if you’re comfortable with your classification of workers for federal tax purposes, it’s important to consider their treatment for other purposes, such as state taxation and federal and state wage and hour regulations. Treating workers as employees for some purposes and independent contractors for others can pose a significant administrative burden, so examine their status for all purposes before making your final decision.

DOL issues new independent contractor rule

Different jurisdictions and agencies may apply different principles in determining a worker’s status. For example, the U.S. Department of Labor (DOL) recently issued a final rule updating its guidance and rescinding its previous employer-friendly rule in favor of a six-factor test.

Although the DOL considers many of the same factors as the IRS, its inquiry focuses on whether, as a matter of “economic reality,” a worker is “economically dependent on an employer.” As explained in the DOL’s Small Entity Compliance Guide, courts have interpreted the economic reality test to be broader than the control test applied by the IRS. As a result, “some workers who may be classified as independent contractors for tax purposes may be employees for (purposes of the Fair Labor and Standards Act).”

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