Employee vs. Independent Contractor: A Guide to Worker Classification

In this guide, we’ll explain the key factors used to classify workers, the consequences of misclassification, and how state laws can differ. For legal advice tailored to your unique business needs, consider reaching out to a local employment law attorney who represents employers.

Why Does Worker Classification Matter?

Correct classification directly impacts your payroll taxes and other responsibilities. For each employee, you must withhold income tax, Social Security, and Medicare taxes and issue them a Form W-2. You are not required to withhold these taxes for an independent contractor, who is considered self-employed and receives a Form 1099-NEC.

Your legal duties to provide benefits can also depend on classification. For example, laws like the Affordable Care Act (ACA) require certain-size businesses to provide health insurance to their employees. Misclassifying an employee as an independent contractor can lead to significant fines, back taxes, and other penalties.

The Six-Factor Economic Reality Test

To determine a worker’s status, courts and the U.S. Department of Labor (DOL) use a six-factor “economic reality” test. No single factor is decisive. Instead, they weigh them together to understand the full nature of the working relationship. The factors are:

• Opportunity for Profit or Loss: An independent contractor can earn more by marketing their services or lose money through poor management. An employee‘s earnings are typically determined by the employer.
• Worker’s Investment: Independent contractors often invest in their own tools, equipment, and resources to run their business. If the company provides all necessary equipment, it points toward an employee relationship.
• Permanence of the Relationship: A project-based or temporary relationship for a specific job suggests an independent contractor. An ongoing, indefinite, or exclusive relationship points toward an employee.
• Company’s Control: This is a key factor. An employer controls what work is done and how it’s done, including the worker’s schedule and methods. An independent contractor controls their own methods and schedule.
• Work’s Role in the Business: If the worker’s job is a critical, necessary, or central part of the company’s core business, they are more likely to be an employee. Work that is separate from or incidental to the primary business suggests a contractor.
• Skill and Initiative: Independent contractors typically bring specialized skills to a project and operate independently. An employee is more likely to be trained by the company for the specific job.

The chart below illustrates how these factors can weigh in favor of classification as an employee or independent contractor. 

State Laws and the “ABC Test”

Some states have stricter rules than the federal government. For example, California, Massachusetts, and New Jersey use a simpler but more rigid “ABC Test.” Under this method, a worker is presumed to be an employee unless the employer can prove all three of the following conditions:

• The worker is free from the control and direction of the hiring entity
• The work is performed outside the usual course of the hiring entity’s business
• The worker is customarily engaged in an independently established trade, occupation, or business

State laws can be stricter than federal guidelines and carry more severe penalties. If you have questions about a worker’s status, consider consulting with an employment law attorney in your area to ensure compliance.

Getting an Official Determination

If you’re uncertain about how to classify a worker, you can ask the IRS for an official determination by filing Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. When you file Form SS-8, the IRS evaluates the entire relationship by grouping evidence into three categories:

• Behavioral Control
• Financial Control
• Type of Relationship

These categories cover the same core issues as the six-factor test, focusing on who has the right to direct and control the work and its financial aspects. While the process can take several months, getting it right is essential.

If you discover you have already misclassified workers, the IRS may offer relief from some fines and back taxes if you can show you had a reasonable basis for the classification and met all tax filing requirements. This is a good time to speak with an employment law attorney.

Consequences of Misclassification

If a worker is classified as an employee, they gain protections under federal and state wage-and-hour laws. The federal Fair Labor Standards Act (FLSA) requires employers to pay employees at least the federal minimum wage and overtime pay at 1.5 times their regular rate for any hours worked over 40 in a week. True independent contractors are not entitled to these protections.

Some employees may be “exempt” from these overtime rules based on their salary and job duties, such as certain executive, administrative, or professional roles. However, these exemptions are specific and narrowly defined.

Misclassifying an employee or wrongly treating them as exempt when they aren’t can lead to significant legal and financial penalties. This is often more than most small businesses can easily absorb, so do your best to be certain about your employee classifications.

How an Attorney Can Help

You’ll face fines and back taxes if you misclassify employees as independent contractors. Correct classification allows your business to avoid penalties and legal hassles. If you have any remaining doubts about how to classify your workers, a local employment law attorney can help.