IRS Worker Classification: Employee vs. Contractor

Determining whether a worker is an employee or an independent contractor is a decision that directly impacts federal tax obligations, withholding requirements, and reporting duties. The Internal Revenue Service (IRS) defines an employee as anyone who performs services for a business that can control what will be done and how it will be done. In contrast, an independent contractor is self-employed and retains control over the method and means of accomplishing their work.

Misclassifying a worker can lead to liability for back taxes and penalties. The classification is based on the substance of the working relationship, and businesses must understand the factors the IRS examines when engaging a new worker.

The IRS Control Tests for Classification

The IRS determines a worker’s status by evaluating the degree of control and independence in the working relationship. This analysis is organized into three categories of evidence: Behavioral Control, Financial Control, and the Relationship of the Parties. The IRS looks at the complete picture of the working arrangement, as no single factor is decisive.

Behavioral Control

Behavioral control focuses on whether the business has the right to direct and control how the worker performs their tasks. A consideration is the type and extent of instructions the business provides. If a company gives detailed instructions about when, where, and how work must be done, this suggests an employer-employee relationship.

Providing training is another indicator of behavioral control. When a business requires a worker to undergo specific training to perform services in a particular manner, it implies the business is directing the methods used. Independent contractors are expected to possess the necessary expertise and do not receive training from the client. Evaluation systems that measure the details of how the work is performed, rather than just the final result, also point toward an employee status.

Financial Control

Financial control examines the business aspects of the worker’s job. The worker’s investment in the equipment and facilities used to perform the services is a factor. Independent contractors often have a substantial investment in their own tools and office space, indicating they bear some risk of loss, while an employee uses tools and equipment provided by the employer.

The method of payment is another financial consideration. Employees are guaranteed a regular wage, such as an hourly or salaried amount, while contractors are more commonly paid a flat fee for a project. The ability of a worker to realize a profit or loss is a hallmark of an independent contractor, who can make business decisions that affect their bottom line. Businesses reimburse employees for job-related costs, whereas independent contractors usually incorporate such expenses into their overall fee.

Relationship of the Parties

This category looks at how the worker and the business perceive their relationship. Written contracts describing the intended relationship can be evidence, but the label given is not the determining factor. The substance of the agreement and the actual working conditions carry more weight.

Providing employee-type benefits is an indicator of an employer-employee relationship. Offering benefits such as health insurance, paid time off, or a retirement plan is characteristic of employment. Independent contractors are responsible for securing their own insurance and retirement plans. The permanency of the relationship is also a factor, as a relationship expected to continue indefinitely suggests employment. The IRS also considers if the worker’s services are integral to the company’s core operations.

Tax Implications of Classification

A worker’s classification as an employee or independent contractor creates different tax obligations for both the business and the worker. These differences involve tax withholding, employment tax payments, and annual reporting. Misclassification can lead to tax liabilities, so it is important to understand these responsibilities.

For employees, the employer handles a large portion of the tax administration. The business must withhold federal income tax from an employee’s wages based on their Form W-4 information. The employer also withholds the employee’s share of Social Security and Medicare taxes, known as FICA taxes.

In addition to withholding, the employer must pay its own matching share of FICA taxes. The business also pays Federal Unemployment Tax (FUTA) on employee wages up to an annual limit. Annually, the employer reports the employee’s total wages and amounts withheld on Form W-2, Wage and Tax Statement.

When a worker is an independent contractor, the tax responsibilities shift to the worker. The business does not withhold any taxes from payments made to the contractor. The independent contractor is considered self-employed and is responsible for paying their own income tax directly to the IRS, typically through quarterly estimated tax payments.

Contractors must also pay the full amount of self-employment tax, which covers both the employee and employer portions of Social Security and Medicare taxes. The business must report payments totaling $600 or more in a year to an independent contractor on Form 1099-NEC, Nonemployee Compensation.

Requesting an Official IRS Determination

If a business or worker is uncertain about the classification, they can request a formal determination from the IRS by filing Form SS-8, “Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.” The form can be submitted by either party, and the IRS will issue a binding determination based on the facts provided.

Completing Form SS-8 requires providing detailed information about the working relationship that aligns with the control tests. Filers must be prepared to provide documentation, such as written agreements, and specific details about job duties, supervision, and payment. The form requires explanations of instructions and training for behavioral control, details on investments and expenses for financial control, and information on benefits and the permanency of the work for the relationship of the parties.

The current version of Form SS-8 is available on the IRS website. The form must be completed accurately, as incomplete submissions may be returned without a determination. After submission, the IRS reviews the information and may contact both parties before issuing its determination, a process that can take six months or more.

Correcting a Prior Misclassification

If a business discovers it has misclassified employees as independent contractors, it can correct the error through the Voluntary Classification Settlement Program (VCSP). The VCSP allows eligible businesses to reclassify workers as employees for future tax periods with partial relief from past federal employment tax liability.

To be eligible for the VCSP, a business must have consistently treated the workers as nonemployees and filed all required Forms 1099 for them for the previous three years. A business is not eligible if it is currently under an employment tax audit by the IRS, the Department of Labor, or a state agency regarding worker classification.

The application is initiated by filing Form 8952, “Application for Voluntary Classification Settlement Program,” at least 120 days before the business wants to begin treating the workers as employees. As part of the application, the business agrees to treat the workers as employees going forward. In exchange for relief from past liabilities, the business pays 10% of the employment tax liability that would have been due on the workers’ compensation for the most recent tax year.

After the IRS reviews Form 8952 and verifies eligibility, the business executes a closing agreement with the IRS to finalize the settlement, at which point the payment becomes due. Participating in the VCSP helps the business avoid a potentially costly audit for prior years and provides certainty for future tax periods.