Employee or Contractor? Understanding the Legal and Financial Implications of Worker Classification

Correctly classifying workers as employees or independent contractors is a critical responsibility for business owners. Employers often do not realize they do not have the option to choose how to classify a worker.  While the distinction may seem straightforward, the consequences of misclassification can be severe, ranging from back taxes and penalties to potential lawsuits and reputational damage.

This article provides an overview of worker classification, including:

• Key factors that determine employee versus contractor status

• Potential risks associated with misclassification

• Steps to take if a worker is misclassified

• Best practices to ensure compliance and protect the business

Defining the Difference: Employee vs. Independent Contractor

The classification of a worker as either an employee or an independent contractor is primarily determined by the degree of control and independence in the working relationship.

Employees

An individual is classified as an employee if the employer controls both:

• The result of the work

• The means and methods used to accomplish the work

Employers typically establish work schedules, provide detailed instructions, and manage the overall performance of employees. Employees often receive benefits such as health insurance, paid time off, and retirement plans.

Independent Contractors

Conversely, an independent contractor maintains control over how the work is completed, with the hiring entity having authority only over the outcome of the work. Independent contractors typically:

• Operate under their own business name

• Supply their own tools and equipment

• Set their own work schedules and determine the manner in which tasks are completed

• Have the ability to work for multiple clients

It is important to note that a written contract designating a worker as an independent contractor is not sufficient to guarantee proper classification. The actual relationship and degree of control exercised by the employer are what determine classification.

The IRS’s Three-Factor Test: How Classification is Determined

The Internal Revenue Service (IRS) utilizes a three-factor test to assess whether a worker should be classified as an employee or an independent contractor. This evaluation focuses on the following criteria:

1. Behavioral Control

• Does the employer control or have the right to control what the worker does and how the work is performed?

• Behavioral control includes instructions regarding when, where, and how the work is completed, as well as training provided to the worker.

2. Financial Control

• Does the employer control the financial aspects of the worker’s job?

• Financial control includes factors such as who determines the payment structure, who reimburses expenses, and who supplies tools and materials.

3. Type of Relationship

• Are there written contracts or employee-type benefits such as pension plans, insurance, or paid time off?

• Is the relationship ongoing, and is the work performed a key aspect of the business?

Important Note:
No single factor determines classification. The IRS considers the entire relationship when making a determination.

Consequences of Misclassification

Misclassifying employees as independent contractors can result in significant financial and legal repercussions. The IRS and other regulatory agencies have increased scrutiny on worker classification, and non-compliance can lead to severe consequences, including:

• Liability for Unpaid Employment Taxes: Employers may be required to pay back taxes, including Social Security, Medicare, and federal income tax withholdings.

• Accuracy-Related Penalties: A 20% penalty may be imposed if the misclassification is determined to be due to negligence or disregard of regulations.

• Failure-to-File Penalties: If tax returns were not filed as a result of misclassification, penalties of 5% per month, up to 25% of the unpaid tax, can be assessed.

• State Penalties: Many states impose their own fines and penalties for misclassification, which may vary based on local regulations.

Addressing a Worker’s Refusal to Complete a W-4

Occasionally, workers may refuse to complete Form W-4 by claiming they are independent contractors. However, classification is not based on a worker’s preference or assertion. It is determined by an objective assessment of the relationship.

If a worker refuses to complete Form W-4:

• Evaluate the Relationship: Assess the nature of the working relationship using the IRS’s three-factor test.

• Require Compliance if Classified as an Employee: If the worker qualifies as an employee, they are required to complete Form W-4 to ensure proper tax withholding.

• Document Classification Decisions: Maintain thorough records to demonstrate compliance in the event of an audit or inquiry.

Employers should never accept a worker’s claim of independent contractor status without a thorough evaluation. Misclassification risks fall squarely on the employer, regardless of the worker’s assertions.

Correcting Misclassification: Steps for Employers

If an employer discovers that a worker was misclassified as an independent contractor, corrective action should be taken immediately to minimize penalties and demonstrate good faith compliance.

Steps to Correct Misclassification:

1. Amend Past Filings:
   Correct previously filed tax returns to accurately reflect the worker’s classification and pay any back taxes owed, including Social Security and Medicare contributions.

2. Consider the Voluntary Classification Settlement Program (VCSP):
   The IRS offers the VCSP, which allows eligible employers to reclassify workers as employees for future tax periods. The VCSP provides partial relief from federal employment taxes.

   • To participate, employers must submit Form 8952 at least 60 days before they intend to treat workers as employees.

3. Update Internal Policies and Procedures:
   Review and revise hiring and classification policies to ensure compliance with IRS guidelines moving forward.

4. Seek Professional Guidance:
   Consult legal and tax professionals to ensure that all corrective actions are properly implemented and documented.

Taking these steps proactively can help mitigate potential penalties and demonstrate a commitment to compliance.

Best Practices to Avoid Misclassification

Preventing misclassification requires a proactive and informed approach. Employers should adopt the following best practices to safeguard their business:

• Conduct Regular Audits: Periodically review worker classifications to ensure ongoing compliance with IRS regulations.

• Educate HR and Hiring Managers: Provide training on classification guidelines to empower HR professionals and hiring managers to make informed decisions.

• Maintain Comprehensive Documentation: Keep detailed records of contracts, work arrangements, and classification decisions to support compliance efforts.

• Consult Professionals When in Doubt: When uncertainty arises regarding classification, seek guidance from experienced legal or tax advisors.

Proper classification not only protects a business from financial penalties but also fosters trust with workers and ensures compliance with federal and state regulations.

Conclusion: Why Classification Matters for Your Business

Worker classification is not just a legal obligation, it is a safeguard against potential financial and operational risks. Misclassification can result in devastating consequences for businesses, ranging from tax liabilities and penalties to damaged reputation and loss of trust.

Employers who take a proactive approach to classification, remain vigilant about compliance, and seek professional advice when needed can minimize these risks and ensure that their business operations remain legally sound.

References:

Internal Revenue Service. (n.d.). Independent Contractor (Self-Employed) or Employee? Retrieved March 24, 2025, from https://www.irs.gov/businesses/small-businesses-self-employed/independent-contractor-self-employed-or-employee

Internal Revenue Service. (n.d.). Accuracy-Related Penalty. Retrieved March 24, 2025, from https://www.irs.gov/payments/accuracy-related-penalty

Internal Revenue Service. (n.d.). Voluntary Classification Settlement Program (VCSP). Retrieved March 24, 2025, from https://www.irs.gov/businesses/small-businesses-self-employed/voluntary-classification-settlement-program

Internal Revenue Service. (n.d.). Worker Classification 101: Employee or Independent Contractor. Retrieved March 24, 2025, from https://www.irs.gov/newsroom/worker-classification-101-employee-or-independent-contractor

Internal Revenue Service. (n.d.). Failure to File Penalty. Retrieved March 24, 2025, from https://www.irs.gov/irm/part4/irm_04-023-009