Tax Implications of Employees vs. Independent Contractors

The Internal Revenue Service collects more than $1 trillion in employment taxes every year. Because employment taxes are one of the most significant and consistent sources of tax revenue, the IRS closely monitors how businesses classify workers. Determining whether workers are employees or independent contractors directly impacts a business’ tax responsibilities and risk, as worker misclassification can lead to significant tax liabilities, audits, and penalties for a business.  

Why the Classification Matters 

Worker classification directly determines which party becomes responsible for tax withholding and reporting, as well as which party is allowed to deduct certain expenses.  

Generally, employers must withhold and deposit an employee’s income taxes, Social Security taxes, and Medicare taxes from the employee’s wages. Employers must also pay the matching employer portion of Social Security and Medicare taxes and pay unemployment tax on wages paid to an employee. The employee’s taxes are withheld at its source, and the employee is not permitted to deduct business expenses. 

For independent contractors, businesses only report payments on Form 1099-NEC and are not responsible for employment taxes. Instead, the independent contractor is responsible for paying their own income taxes and self-employment taxes, which are equal to the employee and employer share of Social Security and Medicare taxes. Depending on how the business is structured, the independent contractor may also be permitted to deduct business expenses on the appropriate tax form. 

The difference in classification is significant, and from an employer’s perspective, employees generally cost more than independent contractors due to employee-specific expenses. Accordingly, businesses may attempt to classify workers as independent contractors, but misclassification has serious consequences. 

How Misclassification Impacts Businesses 

The cost of classifying workers incorrectly can be significant. Employers face the risk of paying back taxes for failing to withhold and remit payroll taxes, interest on unpaid amounts, and significant penalties for failure to file correct returns. 

For many businesses, these additional costs can be financially devastating. Even when misclassification occurs unintentionally, the IRS can assess back taxes and interest for years, so it’s important to know what factors the IRS looks to in making a worker classification. 

How the IRS Determines Worker Classification 

Generally, an employee is an individual who performs services for a business and is subject to the business’s control regarding what will be done and how it will be done. Conversely, an independent contractor can be described as an individual who performs services for a business, but the business only controls the result of the work.  

IRC Sec. 3121(d)(2) defines an employee as “any individual who, under the usual common law rules applicable in determining the employer-employee relationship, has the status of an employee.” Moreover, the Supreme Court has held that where a federal statute does not provide an operational definition of employee, courts should look to common-law rules.  

Applying those standards, courts evaluating worker status for federal employment tax purposes consider the following factors: 

1. Degree of control exercised by the principal; 
2. Investment in work facilities; 
3. Opportunity for profit or loss; 
4. Whether the principal can discharge the individual; 
5. Whether the work is part of the principal’s regular business; 
6. Permanency of the relationship; and 
7. The relationship the parties believed they were creating. 

No single factor is determinative, but courts have held that the control factor is “crucial” in determining the nature of the relationship. 

The IRS looks to the same common-law rules in classifying workers, and it does so on a case-by-case basis. However, it also looks specifically to three factors that provide evidence of control: 

1. Behavioral Control: Does the company control or have the right to control what the worker does and how the worker does their job? 
2. Financial Control: Are the business aspects of the worker’s job controlled by the payer? These include things like how the worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc. 
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? 

Businesses should weigh these factors when determining whether a worker is an employee or independent contractor.  

How Businesses Can Manage Risk 

Businesses should carefully document the factors they used in making an employee/independent contractor determination and take the following steps to reduce risk:  

• Review existing relationships and worker classifications to identify potential problems and maintain consistency 
• Use written contracts carefully (contracts are not determinative, but they can be valuable in making a worker classification) 
• Maintain documentation 

Businesses or workers can also request an official worker classification status from the IRS via Form SS-8. But this result is binding on all parties, so professional outreach first is often the wiser approach. 

Even with the IRS’s guidelines, classification often depends on subtle nuances, and no two situations are identical. If your business has potential worker classification issues, our Tax Controversy Team specializes in helping businesses navigate complex tax matters with the IRS. Contact our team below if you have any questions or need assistance evaluating your workplace structure.