Employee or Contractor? Why Getting It Wrong Can Cost Your Business Dearly

Each year, the Internal Revenue Service collects over a trillion dollars in employment-related taxes. Because payroll taxes represent one of the government’s most stable revenue streams, the IRS closely examines how companies classify their workers. Whether someone is labeled as an employee or an independent contractor has a direct impact on tax responsibilities, compliance risk, and potential exposure to costly penalties.

Why Worker Classification Is So Important

A worker’s classification determines who pays and reports taxes, who can claim certain deductions, and what filing obligations exist.

For employees, the employer must withhold and remit income tax, Social Security, and Medicare contributions directly from wages. In addition, employers pay a matching share of Social Security and Medicare taxes and cover federal and state unemployment taxes. Employees cannot deduct job-related expenses on their personal tax returns.

Independent contractors, by contrast, are treated as self-employed. Businesses that hire them issue a Form 1099-NEC to report payments but do not withhold taxes. Contractors handle their own income and self-employment taxes—essentially paying both the employer and employee portions of Social Security and Medicare. Depending on the business structure, they may also deduct eligible business expenses on their returns.

The distinction carries real financial weight: hiring an employee typically costs a company significantly more than hiring a contractor. This sometimes tempts businesses to lean toward contractor classification—an error that can backfire if the IRS later disagrees.

The High Cost of Misclassification

When a company mislabels workers, the financial consequences can be severe. The IRS can require back payment of employment taxes, interest on unpaid amounts, and substantial penalties for failing to withhold or file correctly.

Even unintentional mistakes can trigger multi-year liabilities, often large enough to jeopardize a business’s cash flow. Because of this, understanding how the IRS evaluates these relationships is essential to reducing risk.

How the IRS Decides: Control Is Key

The IRS and courts apply common-law principles to determine a worker’s true status. In short, an employee is someone whose work and methods are directed or controlled by the employer. An independent contractor, however, decides how the job is performed and remains responsible for their own results.

Courts have historically examined several factors, including:

• The amount of control the company exerts
• The worker’s investment in tools or facilities
• The chance for profit or loss
• Whether the company can terminate the worker
• Whether the work is part of the company’s core business
• The length and regularity of the relationship
• The intent of both parties when the relationship began

No single element decides the issue, but the right to control remains the most significant factor.

The IRS’s Three-Part Test

In modern practice, the IRS simplifies these common-law principles into three core categories of control:

• Behavioral Control – Does the company dictate how, when, and where the work is done?
• Financial Control – Who manages the business aspects of the job? This includes payment structure, reimbursement of expenses, and ownership of tools or materials.
• Type of Relationship – Are there written contracts or employee-style benefits such as vacation pay or insurance? Does the relationship appear ongoing, and is the service integral to the company’s operations?

The IRS weighs all these factors together, examining the substance of the relationship, not just what the paperwork says.

Reducing Classification Risks

To minimize exposure, businesses should take proactive steps:

• Audit existing worker relationships to ensure consistent and defensible classifications.
• Document the reasoning behind each classification, especially where roles could be viewed either way.
• Use contracts thoughtfully—they help define expectations but are not, by themselves, proof of independent status.
• Retain detailed records showing how the relationship functions in practice.

In some cases, companies or workers may file Form SS-8 to request an official IRS determination of status. However, because the IRS’s decision is binding on all parties, professional consultation beforehand is strongly recommended.

The Bottom Line

Misclassifying workers can lead to unexpected tax liabilities, costly audits, and operational disruption. Since each situation turns on nuanced facts, even well-intentioned employers can make mistakes. Understanding how the IRS applies its control tests—and maintaining documentation that supports your position—is the most reliable defense.

About ICT Lions

At ICT Lions, we help businesses on both sides of the Atlantic manage complex tax and compliance challenges—including worker classification, payroll structures, and IRS examinations. With deep expertise in U.S. and international tax systems, our advisors guide companies through every stage of compliance and resolution with clarity and confidence.