Employee or Independent Contractor? That is the Question

Employee or Independent Contractor? That is the Question

During National Small Business Week in September 2021, the IRS issued a news release reminding business owners to correctly identify their workers as employees or independent subcontractorsi. Though there were no significant changes in the rules in this regard during the year, the IRS discovers classification errors regularly that subject employers to costly penalties.

With the entry of COVID-19 into the U.S. economy in 2020, there were lockdowns and voluntary shifts in where employees worked, many moving to working from home. As companies found that productivity remained normal, their costs could be reduced due to the shrinking of office space necessary for operations. Then many found that changing workers from employees to independent contractors would result in more savings. The gig economy has been growing by leaps and bounds.

Businesses must adhere to IRS classification rules to make proper decisions as to status as employee or independent contractor. The key considerations involve the type of relationship and the business’ control over the workerii.

Type of Relationship

In many cases, the independent contractor will have a written contract with the business, but many gig workers are less formal, working with minimal informal agreements as to work to be done and compensation for that work. The independent contractor often does not have an ongoing relationship with the client, working sporadically or on a one-time project basis. The IRS may also look to see if the work the independent contractor is providing is a “key aspect” of the client’s business.

Most independent contractors receive no benefits, insurance, or vacation from the employing business. The key thing for the business owner to remember is that just executing a written agreement with a worker does not confer independent contractor status unless all the IRS tests verify that status.

Aspects of Control

The IRS has a “right to control” test that is used in the determination of status. Along with the relationship aspect, there are two other areas of consideration:

  • Behavioral Control – Does the employer have the right or exhibit the ability to control the work of the hired person? Among other things, the employer should not be controlling when or where the work is done. Another flag is when an independent contractor is doing the same work as others who are carried as employees. If so, the IRS is likely to classify them as an employee.
  • Financial Control – Unlike an employee, the independent contractor is likely to have work-related expenses that are not reimbursed by the business. They will also have money invested in facilities or “tools of the trade” to provide their services. One example could be their own computer, while one provided by the business could create a problem with classification as an independent contractor.


Most incidences of misclassification involve the desire of the business to cut costs that are involved with the hire and use of employees, including:

  • Employer’s share of Social Security and Medicare taxes.
  • Employee benefits
  • Unemployment taxes
  • Workers compensation insurance
  • Overtime pay

Knowing that there are more severe penalties for employers that intentionally misclassify employees, these for unintentional misclassification are bad enough. If all payments to misclassified independent contractors are reclassified as wages, the following penalties can apply:

  • For each Form W-2 that was not filed for those misclassified workers, there is a $50 fine.
  • As the employer did not do withholding for the misclassified independent contractor, penalties include 1/5% of the wages plus 40% of the Social Security and Medicare taxes that were not withheld. This is besides all the FICA taxes that should have been paid with interest compounded daily.
  • A Failure to Pay Taxes penalty equal to 0.5% of the unpaid tax liability for each month up to 25% of the total tax liability.

As with most tax related rules and regulations, consultation with a tax professional or accountant is a wise idea.

i IRS reminds business owners to correctly identify workers as employees or independent contractors – IRS.gov

ii Improperly classifying employees as independent contractors – Justworks.com


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