Independent Contractor vs. Employee Classification
Many workers in the United States are classified as independent contractors (ICs) rather than as employees. While IC status is appropriate in many situations, workers are often—sometimes intentionally—misclassified to reduce labor costs. Misclassification matters because independent contractors generally are not entitled to many legal protections and benefits provided to employees.
Why Employers Misclassify Workers
Employers may save money by classifying workers as independent contractors because ICs are typically not entitled to:
- An employer’s share of Social Security (FICA) and Medicare taxes
- Overtime and minimum wage payments
- Employee health insurance premiums
- Employee retirement benefits, vacation, holiday, and sick pay
- Other employee fringe benefits, such as stock options
- Federal and state unemployment compensation taxes (FUTA and SUTA)
- Workers’ compensation insurance premiums
Regulatory Enforcement: IRS, DOL, and State Agencies
Regulators take worker misclassification seriously. Unreported or underreported employment taxes contribute to the federal tax gap, and the IRS can pursue back taxes and penalties against employers that improperly classify workers as self-employed contractors.
The U.S. Department of Labor (DOL), the Department of Justice (DOJ), and state counterparts also enforce proper classification. Workers who believe they were misclassified may file a complaint with the DOL or the relevant state labor or unemployment agency. In recent years, regulators have scrutinized classification practices in the gig economy and app-based work arrangements.
Penalties and Legal Exposure for Misclassification
Federal penalties can be severe, and outcomes depend on whether the misclassification is deemed unintentional, intentional, or fraudulent.
- Unintentional misclassification: the employer may face penalties because payments to misclassified ICs can be reclassified as wages.
- Intentional or fraudulent misclassification: the IRS may impose additional fines and penalties, and criminal exposure is possible in extreme cases.
Criminal penalties may be assessed and courts can impose prison sentences in appropriate circumstances. Individuals responsible for withholding payroll taxes can also face personal liability under the responsible person penalty statute and related state laws.
Misclassified workers may be entitled to recover wages, overtime, and other compensation. After federal action, matters may also be referred to state tax or labor authorities, which can impose their own back taxes, interest, fines, and penalties.
Employers also may face private litigation, including individual lawsuits and class actions—a particularly common trend in employee-friendly jurisdictions such as California.
How Do You Determine Employee vs. Independent Contractor?
One of the most difficult issues for employers is determining whether a worker should be classified as an employee or an independent contractor. Multiple tests may apply depending on the agency and the legal context. At the federal payroll tax level, two tests are commonly referenced:
- Common law 20-factor test
- IRS three-factor test (behavioral control, financial control, and relationship control)
Common Law 20-Factor Test (Right of Control)
The common law test evaluates the employer’s right to direct and control the worker. The 20 commonly cited factors include:
- Level of instruction
- Amount of training
- Degree of business integration
- Extent of personal services
- Control of assistants
- Continuity of relationship
- Flexibility of schedule
- Demands for full-time work
- Need for on-site services
- Sequence of work
- Requirements for reports
- Method of payment
- Payment of business or travel expenses
- Provision of tools and materials
- Investment in facilities
- Realization of profit or loss
- Work for multiple companies
- Availability to public
- Control over discharge
- Right of termination
IRS Three-Factor Test
Although the IRS historically referenced the 20-factor test, it now evaluates the relationship by grouping evidence into three broad categories:
behavioral control, financial control, and relationship control. The practical approach is to consider all information that shows whether the putative employer retains the right to control the worker.
Behavioral control
Behavioral control focuses on whether the company controls—or has the right to control—what the worker does and how the job is performed. Factors include the type and degree of instructions given, evaluation systems, and training.
Financial control
Financial control examines who controls the economic aspects of the worker’s job. Indicators of independent contractor status may include working for multiple clients and providing one’s own tools. Indicators of employee status may include reimbursement of expenses and payment based on hours worked.
Financial control factors often include: significant investment, unreimbursed expenses, opportunity for profit or loss, availability of services to the market, and method of payment.
Relationship control
Relationship control looks at how the parties perceive the relationship. Providing paid vacation and retirement benefits may suggest employee status, as does an indefinite engagement rather than a project for a defined time period. Contract language calling the worker an IC is not determinative by itself.
Common factors include: written contracts, provision of employee benefits, permanency of the relationship, and whether the services are a key activity of the business.
Key Takeaway
Employers must weigh all relevant factors when determining whether a worker is an employee or an independent contractor. There is no fixed number of factors that decides the outcome, and no single factor controls in every situation. The most defensible approach is to examine the entire relationship, evaluate the degree of the right to direct and control, and document the basis for the classification decision.