How to Classify Independent Contractors vs. Employees
How to Classify Independent Contractors vs. Employees

How to Classify Independent Contractors vs. Employees

It’s 2020, the gig economy is booming, and independent contractors are in high demand. . A 2018 study conducted by UpWork and The Freelancers’ Union found that more than one in three Americans freelanced last year. More importantly, over the past five years, the freelance workforce has increased by 3.7 million to 56.7 million. With more businesses partnering with independent contractors, it’s essential to ensure workers are properly classified.

Employees vs. Independent Contractors

Aside from taxes, the biggest difference between employees and contractors is the level of control the employer has over the worker.

Typically, an employer that partners with an independent contractor defines the scope of work but doesn’t have control over how, where or when the work is completed. Because the independent contractor often uses their own tools and equipment, expenses aren’t usually reimbursed.

Independent contractors are just that… independent. They’re either paid by the project or by the hour, they set their own schedules, they can work offsite, and unlike employees, their work usually isn’t key to the success of the business.

How the IRS Determines Classifications

The IRS considers three categories when classifying independent contractors:

  1. Behavioral Control
  2. Financial Control
  3. Type of Relationship

  Behavioral Control  Financial Control  Type of Relationship 
Employee  Has on-the-job training, set hours and guidelines for how their work should be completed.   The worker has guaranteed wages or salary.  Receives employee benefits (e.g., PTO, insurance, pension plans, etc.) 
Independent Contractor  Sets their own hours and decides how the project should be completed. Paid a flat fee per project or hour.  Contracted for a set time or number of projects. 



When determining the classification of an employee, keep this IRS quote in mind:

“There is no 'magic' or set number of factors that 'makes' the worker an employee or an independent contractor, and no one factor stands alone in making this determination. Also, factors that are relevant in one situation may not be relevant in another”.

The Two Major Penalties for Misclassifying Employees

  1. Fines and Back Pay: If the Department of Labor (DOL) determines that misclassification was unintentional, an employer may be hit with:
    • $50 for each unfiled W-2
    • 1.5% of the worker’s wages, with interest
    • 40% of the worker’s FICA contributions (Social Security and Medicare)
    • 100% of the employer’s FICA matching contributions
    However, if the DOL determines misclassification was intentional, an employer may be responsible for:
    • Maximum penalty of one year in prison
    • Up to $1,000 in criminal penalties for each misclassified employee
    • 20% of all employee wages paid
    • 100% of FICA contributions for both employer and employee
  2. Benefits: If a misclassified employee files a complaint with the DOL, they may be eligible for benefits owed, including:
    • Overtime
    • PTO
    • Health and welfare coverage
    • 401(k) contributions

Monetary fines aren’t the only challenge you’ll have to overcome. Fines and class action lawsuits can significantly tarnish your brand image, making it harder to recruit top talent, retain clients and grow. Together, these penalties can threaten the survival of any small to medium-sized business.

Six Basic Tips to Protect Your Business from Misclassifications

  1. Ensure you have a written contract in place for each independent contractor explaining their classification.
  2. State in the contract that independent contractors are not entitled to employee benefits.
  3. Provide all independent contractors with Form 1099 as required by the IRS.
  4. Document the factors you used to determine the worker’s classification.
  5. Obtain a worker’s full name, address and Social Security number before you pay them.
  6. Review your employee handbook and job descriptions to ensure workers’ duties are in line with what their roles demand.
Keep in mind: The IRS will assist you in determining the classification of a worker. All you need to do is file Form SS-8. Until the IRS makes a decision, you should treat the worker as an employee.

independent contractor vs employee

Can a Worker Be Both an Employee and an Independent Contractor?

Here’s a puzzle: What if you employ a full-time worker and they also do the occasional contracted work for your business on the side? Can you pay this worker as both a W-2 employee and as an independent contractor?

The safest bet would be to classify and pay this worker entirely as an employee for all the tasks they perform. However, if the employee has an established outside business, and the contracted work doesn’t pertain to this employee’s duties, then you may treat the employee as an independent contractor for that specific work.

For example, if you have an employee who works as a bookkeeper but also has a side photography business, you may be able to hire them as an independent contractor for a photoshoot while paying them as an employee for their normal duties as a bookkeeper.

How Paycor Can Help:

We’re proud to keep more than 30,000 organizations up-to-date and compliant with federal and state employment laws. Interested in learning more? Consult with a Paycor representative.

*This content is for informational and educational purposes only and is not intended to be taken as legal advice. For legal advice, consult with your professional legal or tax advisor.


payroll compliance guide

More to Discover

Paycheck Protection Program (PPP): What You Need to Know About Payroll Protection

Paycheck Protection Program (PPP): What You Need to Know About Payroll Protection

You need payroll protection. The federal government wants to help. Here’s what you need to know. The Paycheck Protection Program (PPP) As part of the $2 trillion aid package unveiled in the Coronavirus Aid Relief & Economic Security (CARES) Act, $349 billion was dedicated to the Payment Protection Program (PPP). This offers federal guaranteed loans to businesses with fewer than 500 employees to cover payroll and other essential costs.The federal government is focused on releasing funds quickly and with as little red tape as possible, giving small businesses a big boost right when they need it. And here’s the best part—if you use the funds to retain (or rehire) your employees, the loans don’t need to be repaid.View Payroll Protection...

Emergency Sick Leave for Childcare: What Employers Need to Know About FFCRA

Emergency Sick Leave for Childcare: What Employers Need to Know About FFCRA

The Families First Coronavirus Response Act (FFCRA) is a big part of the government response to the current public health crisis, offering emergency sick leave and paid family medical leave to those affected by Coronavirus. Take a look at our guide on managing employee leave scenarios.The FFRCA doesn’t just apply to employees who are directly affected by the virus—those who are infected, caring for the infected or quarantined. It also puts in place measures for the parents or guardians of children whose schools or day care facilities are closed due to the pandemic.These measures will apply from April 1, 2020 through December 31, 2020. How Does the FFCRA Work for Parents? If an employee has been on payroll for at least 30 days and cannot...

Essential Business Letter (Template)

Essential Business Letter (Template)

Many states and cities are imposing complete or partial lockdowns, with most businesses forced to temporarily shut their doors or move to remote work and only “essential businesses” unaffected. This has left many employers and employees asking what exactly counts as an essential business.Download Essential Business Letter Template What Counts as an Essential Business? On March 19, the Cybersecurity and Infrastructure Security Agency (CISA, overseen by the Department of Homeland Security) issued guidance on what business count as critical infrastructure. Some businesses are obviously essential—hospitals, pharmacies and law enforcement. The list is extensive—other essential businesses include stores selling supplies which allow people to...

Webinar: COVID-19 Summit - LIVE DEMO: See Paycor's COVID-19 Command Center - 4/23/20 @2pm ET

Webinar: COVID-19 Summit - LIVE DEMO: See Paycor's COVID-19 Command Center - 4/23/20 @2pm ET

Join Paycor’s Senior Product Manager, Kelly Silverman, for a live demonstration on how Paycor is providing HR leaders with the technology and expertise to help them prepare, respond and recover. The demonstration will highlight how Paycor Analytics and HR Support Center can offer the data and resources HR leaders need to mitigate risk and reshape business strategy.Speaker: Kelly Silverman Kelly Silverman is Paycor's resident benefits and HR marketing leader. An HCM industry veteran with a strong product and marketing background, Kelly’s responsibilities include driving the go-to-market strategy for benefits and analytics to Paycor’s customer base.Thursday, April 23, 2020 2pm ET