How To Classify Employee vs. Independent Contractors

How To Classify Employee vs. Independent Contractors

In 2020, we went from a booming economy to an unprecedented unemployment rate we've had in recent times due to the lockdown caused by the novel coronavirus (COVID-19). In 2021, as the economy recovers, more and more businesses are likely to partner with independent contractors. These workers must be properly classified.

You absolutely cannot ignore: in 2021, payment to independent contractors will be reported using a revamped 1099-NEC (NEC stands for non-employee compensation).

Employees vs. independent contractors

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

Usually, an employer who works with an independent contractor defines the field of activity but has no control over how, where, and when the work is completed. Since the independent contractor usually uses its tools and equipment, the costs are usually not reimbursed.

Independent contractors are independent. They are paid by the hour or on a project basis, set their hours, and work offsite, and, unlike employees, their work is often not the key to the business's success.

How the IRS determines the classification

The Internal Revenue Services considers three classes when classifying independent contractors:

  • Behavior control

  • Financial control

  • The type of relationship



Behavioral Control 

Financial Control 

Type of Relationship 


The employee has on-the-job training, schedules, and provides advice on how to complete the job.

The employee has a guaranteed salary or wages.

Receives social benefits (e.g., PTO, insurance, pension plans, etc.)

Independent Contractor 

sets their own plan and decides how to carry out the project.

Is paid a flat rate per project or hour.

Contracted for a certain period or number of projects. 



According to the IRS, "There is no 'magic' or a fixed number of factors that 'make' an employee or independent contractor, and no single factor determines this determination. Moreover, the relevant factors in one situation may not be relevant in another."

The two main penalties for misclassifying employees

Fines and late payments: If the Department of Labor (DOL) determines that the classification error was unintentional, the employer can be fined:

  • $ 50 for any W-2 form not shown

  • 1.5% of the worker's salary, with interest

  • 100% of the employer's FICA contributions

  • 40% of the worker's FICA contributions (including social security and Medicare)

However, if the DOL determines that the classification error was intentional, the employer can be held responsible for:

  • 100% of FICA contributions to the employer and the employee

  • 20% of all employee salaries paid

  • A sentence of one year in prison

  • Up to $ 1000 in criminal penalties for each misclassified employee

Social Benefits: If an incorrectly classified employee files a complaint to the DOL, he/she may be entitled to the benefits due, including:

  • 401 (k) contributions

  • Health and well-being coverage

  • Overtime

  • PTO

Financial fines are not the only difficulty you'll have to overcome. Fines and class actions can dramatically tarnish your brand image, making it difficult to recruit top talent, retain customers, and grow. Together, these sanctions can threaten the survival of any small or medium-sized business.

Some basic tips to protect your business from misclassification

  • Document the factors you used to determine employee evaluation.

  • Establish in the contract that the self-employed are not entitled to social benefits.

  • Make sure you have a written contract for each independent contractor that explains their classification.

  • Obtain the worker's full name, address, and Social Security number before payment.

  • Provide all independent contractors with Form 1099NEC as required by the IRS.

  • Review employee manuals and job descriptions to ensure workers' jobs match what the job requires.

Can a worker be both an independent contractor and an employee?

Here's a conundrum: What if you hire a full-time worker, and they are sometimes contracted to work on the side for your business? Can you pay this worker as an independent contractor and a W-2 employee?

The most reliable thing would be to classify and pay the employee in full as an employee for all the activities performed. However, suppose the employee has a business established outside of yours, and contracted work does not affect their employee's duties. In that case, you can treat them as independent contractors for that specific job.

For instance, suppose you have an employee who works as a marketer and has a parallel HR business. In that case, you can hire them as a freelance contractor for a consultation job, and pay them as an employee for their normal marketing duties.



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