Employees Or Independent Contractors? How To Classify Workers

When you’re a small business, you may not have the resources (nor the need) for a full-time staff. You might choose to have one or two employees who work part-time, one or two who work full-time, or, depending on your circumstances, you might fill in the gaps seasonally by hiring temporary employees. From a tax and employment law perspective, all of them could potentially be your employees.

Sometimes employers assume that only full-time, permanent workers are employees. This is not true. Employees can be full-time or part-time, seasonal or year-round, temporary or permanent. The question of how to classify workers as employees versus independent contractors depends on many factors, but the length of employment is not one of them.

Employee Or Independent Contractor?

What distinguishes an employee from an independent contractor? If a worker is an employee, the employer has certain tax obligations on behalf of the worker. In contrast, an employer does not withhold any payroll taxes, including Social Security and Medicare taxes, nor does it pay the employer portion of those taxes for an independent contractor.

The Internal Revenue Service (IRS) says that the general rule is that an individual is considered an independent contractor if the person paying for the work has the right to control or direct only the result of the work, not the manner in which it is done. Or, to put it simply, it’s a question of control: The more you control the terms of the employment, the more likely it is that you are an employer.

Obviously, control is relevant and cases are fact-specific. In an effort to clarify this, in 1987, the IRS developed a list of 20 factors to be considered. Those were memorialized in Revenue Ruling 87-41. (A revenue ruling is an official interpretation by the IRS of the Internal Revenue Code, related statutes, tax treaties, and regulations, and indicates how the IRS believes the law should be applied to a specific set of facts.)

The 20 factors identified by the IRS in Revenue Ruling 87-41 are listed below. The more the answer to each question is yes, the more likely it is that the worker is an employee and not an independent contractor.

1. Instructions. Is the worker required to comply with another person’s instructions regarding when, where, and how they are to work?
2. Training. Is the worker trained by the employer?
3. Integration. Is the worker an integral part of the employer’s business?
4. Services rendered personally. Is the worker required by the employer to render the services personally?
5. Hiring, supervising, and paying assistants. Is the hiring, supervising, and paying of assistants for the worker done by the employer?
6. Continuing relationship. Is there a continuing relationship between the worker and the employer?
7. Set hours of work. Does the worker have work hours set by the employer?
8. Full time required. Does the worker normally work full-time for the employer to the exclusion of other work?
9. Work done on premises. Is the work performed on the premises of the employer?
10. Order or sequence set. Is the order of the work performed by the worker set by the employer?
11. Oral or written reports. Is the worker required to submit regular or written reports to the employer?
12. Payments by hour, week, or month. Is the worker paid by the hour, week, or month?
13. Payment of expenses. Does the employer ordinarily pay the worker’s business and/or travel expenses?
14. Furnishing of tools and materials. Does the employer provide the worker with the necessary tools, materials, and other equipment?
15. Significant investment. Has the worker made little to no investment in the facilities where they perform services?
16. Profit or loss. Does the employer pay for the worker’s time, regardless of the outcome, thereby protecting the worker from losses or limiting the right to a profit?
17. Working for more than one firm at a time. Is the worker only performing services for one employer?
18. Making services available to the general public. Does the worker limit services to the employer as opposed to making his or her services available to the general public on a regular and consistent basis?
19. Right to discharge. Can the employer discharge the worker?
20. Right to terminate. Can the worker quit at any time without incurring liability?

Of course, that list isn’t written in stone, just in a Revenue Ruling. Some of this is subjective, and there’s no magic number of times you can answer yes that conclusively determines the outcome.

Since that time, the IRS has updated its checklist to three categories of factors to be used alongside the 20 questions.

1. Behavioral Control. Does the company have the right to control what the worker does and how the worker performs their job?
2. Financial Control. Are the business aspects of the worker’s job controlled by the payer?
3. Type of Relationship. Are there written contracts or employee-type benefits? Will the relationship continue, and is the work performed a key aspect of the business?

For IRS purposes, as an employer, you must weigh all these factors to determine whether a worker is an employee or an independent contractor. The IRS also has a helpful section on its website that provides examples and definitions.

Non-Tax Considerations

So is this just about a paycheck? Not at all. Employers have different obligations towards employees than they do towards independent contractors—and that extends beyond tax obligations. For example, an employer is not responsible for providing the same benefits and tax-favored opportunities, such as health care insurance and retirement plans, to an independent contractor that they provide to those workers who are considered employees. An employer is not required to offer stock options or other incentive plans to an independent contractor. And when an independent contractor leaves, for whatever reason, there is generally no severance or unemployment compensation payable. In short, an independent contractor is, well, independent.

Worker classification can also impact wages and overtime pay. That’s why, as part of its efforts to address worker misclassification, the Wage and Hour Division of the Department of Labor (DOL) published a final rule, effective March 11, 2024, revising its guidance on how to analyze whether a worker is an employee or an independent contractor under the Fair Labor Standards Act (FLSA). Additional information is available on the DOL website.

Worker misclassification issues aren’t limited to small businesses. Several high-profile companies, including Microsoft, Time Warner, and Lyft, have faced court cases over allegations of worker misclassification. Perhaps the most famous case involved FedEx, which was accused of classifying and paying its drivers as independent contractors for years (when they should have been classified as employees). After extensive litigation in multiple states, FedEx paid nearly half a billion dollars in settlement payments for misclassification.

Fixing Mistakes

What happens if you do it wrong? As court cases around the country have demonstrated, if you erroneously classify an employee as an independent contractor and you have no reasonable basis for doing so, you may be held liable for employment taxes for that worker. Depending on circumstances, you may be required to retroactively apply benefits.

If you have concerns, you can get out in front of the problem. If you want the IRS to make a determination, you can file Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. (The form may be filed by either the business or the worker.) The IRS will review the facts and circumstances and officially determine the worker’s status. But it’s not quick: it can take at least six months to get a determination.

If you’ve misclassified a worker as an independent contractor, but you have a reasonable basis for doing so, you may qualify under a safe harbor for tax relief. The relief, sometimes referred to as section 530 relief, requires you to meet certain criteria, including treating the worker consistently for filing obligations (for example, you filed Form 1099-NEC for a worker you considered an independent contractor). You must also have treated similar workers as independent contractors.

The IRS also offers a Voluntary Classification Settlement Program (VCSP) that allows employers to reclassify workers as employees for future tax periods and obtain some tax relief. To participate, a business owner must meet certain eligibility requirements (similar to those for section 530 relief).