Contractor or Employee? How the IRS Decides
The three-part common-law test, the state tests that are stricter, what misclassification costs, and the relief programs for getting it right.
Reviewed by the Fairlight Accounting cross-border tax team — U.S. & Canadian Tax Desks
The IRS decides whether a worker is an employee or an independent contractor by who controls the work: how it is done (behavioral control), the economics of the job (financial control), and the nature of the relationship. No single factor decides. Some states apply a stricter ABC test, and misclassifying an employee can cost back payroll taxes, penalties, and benefits.
On this page
What does the IRS look at?
| Category | Points toward employee | Points toward contractor |
|---|---|---|
| Behavioral control | Set hours, training, detailed instructions, required methods | Worker decides how, when, and where |
| Financial control | Paid by the hour, tools provided, no risk of loss, works for one business | Invoices by the job, own equipment, can profit or lose, markets to the public |
| Relationship | Open-ended, benefits provided, work is the core of the business | Written contract for a project, no benefits, work is incidental |
A written contract calling someone a contractor does not settle the question if the facts show control.
How do state tests differ?
Many states use the common-law test for unemployment and workers' compensation, but a growing number use an ABC test, under which a worker is an employee unless the business proves all three: freedom from control, work outside the usual course of the business, and an independently established trade. California applies it broadly. Florida follows a control-based test for most purposes. A worker can be a contractor federally and an employee for state unemployment.
What does misclassification cost?
- The employer share of Social Security and Medicare, plus a portion of the employee share and income tax withholding that should have been taken
- Federal and state unemployment tax
- Penalties and interest, and the trust fund recovery penalty if withheld amounts were not paid
- Retroactive benefits eligibility, overtime claims, and workers' compensation exposure
Reduced rates under Section 3509 apply unless the employer intentionally disregarded the withholding rules: income tax withholding is figured at 1.5 percent of wages and the employee share of Social Security and Medicare at 20 percent of the normal amount, rising to 3 percent and 40 percent if the required 1099s were not filed. The employer share is owed in full.
What relief exists?
- Section 530 relief protects a business that had a reasonable basis for contractor treatment — industry practice, a prior audit, or a court case — treated the workers and anyone in a similar position consistently as contractors, and filed the required 1099s.
- Voluntary Classification Settlement Program lets a business reclassify workers going forward and pay 10 percent of the employment tax liability for the most recent tax year, figured at the reduced Section 3509 rates, with no interest or penalties and no employment tax audit of prior years on those workers' classification. Apply on Form 8952 at least 120 days before the date you want to start treating them as employees.
- Form SS-8 asks the IRS to rule on a worker's status; either party can file.
Frequently asked questions
Can a worker be both?
Yes, for different roles — an employee by day and a contractor for a separate business. For the same role, the facts decide one way.
Does giving a contractor a 1099 protect me?
Filing 1099s is required for Section 530 relief but does not by itself make someone a contractor.
Do part-time workers have to be employees?
Hours do not decide. A part-time receptionist on your schedule is an employee; a graphic designer serving many clients is usually a contractor.
What about workers hired through a staffing agency?
They are generally the agency's employees for payroll tax purposes when the agency pays them and handles payroll, though joint-employer rules can apply for labor law.
Official sources
The IRS explains: “Businesses must weigh all these factors when determining whether a worker is an employee or independent contractor. Some factors may indicate that the worker is an employee, while other factors indicate that the worker is an independent contractor.” — Internal Revenue Service, Independent contractor (self-employed) or employee?, https://www.irs.gov/businesses/small-businesses-self-employed/independent-contractor-self-employed-or-employee
The IRS explains: “To participate in the VCSP, a taxpayer must apply using Form 8952, Application for Voluntary Classification Settlement Program. The application should be filed at least 120 days prior to the date the taxpayer wants to begin treating its workers as employees.” — Internal Revenue Service, Voluntary Classification Settlement Program, https://www.irs.gov/businesses/small-businesses-self-employed/voluntary-classification-settlement-program
Next step
Fairlight Accounting handles U.S. domestic, cross-border (U.S.–Canada), and international tax returns, plus bookkeeping, payroll, and CFO advisory. Our U.S. Tax Desk reviews worker arrangements and handles reclassification when the facts call for it. See pricing or book a free fit call.
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