Misclassifying workers can result in significant tax penalties, back wages, and legal liability. Understanding the distinction is critical for every business.
The IRS examines three categories of evidence:
Behavioral control: Does the company control how and when the work is done? Employees typically follow detailed instructions and set schedules. Contractors control their own methods and hours.
Financial control: Does the worker have unreimbursed business expenses? Do they invest in their own tools and equipment? Can they realize a profit or loss? Are they available to work for multiple clients? Contractors typically answer yes to these questions.
Relationship type: Is there a written contract? Are there employee-type benefits (insurance, retirement, paid time off)? Is the work a key aspect of the business? What is the duration of the relationship?
Some states use the stricter ABC test, which presumes a worker is an employee unless the hiring entity proves all three:
(A) The worker is free from control and direction.
(B) The work is outside the usual course of the hiring entity's business.
(C) The worker has an independently established trade or business.
Tax penalties: Back payment of employment taxes, FICA, unemployment insurance, plus penalties and interest.
Wage claims: Workers can claim unpaid overtime, benefits, and workers' compensation coverage.
Legal action: DOL, IRS, and state agencies can all investigate and impose penalties.