Distinguishing Between Employees and Independent Contractors. IRS Guidance, Legal Risks, and Best Practices

Correctly classifying workers as employees or independent contractors is critical for U.S. business owners, both large and small. As seen in landmark cases like FedEx’s $228 million settlement, missteps in worker classification can lead to costly legal consequences, turning what appear at first to be minor administrative errors into potential threats to a company’s reputation and finances^[web:1]. Understanding the IRS’s standards and the broader legal landscape is essential for small business owners seeking to avoid pitfalls and ensure compliance.

Why Classification Matters

The temptation for business owners to classify workers as independent contractors is strong. Independent contractors, unlike employees, do not require companies to pay payroll taxes, provide healthcare or retirement benefits, or extend federal wage protection and anti-discrimination laws^[web:1]. For businesses, these savings can be significant, especially in industries where labor costs are a primary consideration.

However, misclassification exposes businesses to hefty penalties, back taxes, interest charges, and—in some cases—class-action lawsuits. The implications of a misstep go beyond financial risk: businesses may damage employee trust, attract unwanted regulatory scrutiny, and, in extreme cases, face criminal charges for willful violations.

IRS Criteria: The Common Law Test

The IRS uses what is known as the “common law test” or “control test” to distinguish between employees and independent contractors. This test examines the degree of control that the employer holds over the worker and the work performed. It breaks down into three primary categories:

• Behavioral Control: Does the company control or have the right to control what the worker does and how the worker does their job?
• Financial Control: Are the business aspects of the worker’s job controlled by the payer? This includes things like payment methods, whether expenses are reimbursed, and who provides tools/supplies.
• Type of Relationship: Are there written contracts or employee-type benefits (like pension plans and insurance)? Will the relationship continue, and is the work performed a key aspect of the business?

A worker is generally considered an employee if the business has the right to direct and control the work performed, not just the result. Conversely, a worker qualifies as an independent contractor if they retain the right to control how and when the work is done, typically offer their services to other clients, and bear the risk of profit or loss in their enterprise^{[web:2][web:3]}.

The FedEx Case: A Landmark Event

The FedEx case highlights these principles in dramatic fashion. FedEx classified its drivers as independent contractors—a status attractive for reducing costs but contentious from a legal perspective. Critics argued that FedEx exerted significant control over drivers’ routes, schedules, uniforms, and even vehicles, indicating an employee relationship under IRS criteria^[web:1].

Despite FedEx’s insistence that it had not violated labor laws, the company chose to settle the dispute, paying $228 million to resolve claims by drivers who argued they were, in practice, employees. The scale of the settlement sent a clear warning: businesses must rigorously adhere to classification standards or risk severe consequences.

The Cost of Misclassification

When businesses misclassify employees as independent contractors, the IRS and other authorities can impose:

• Back taxes on Social Security and Medicare contributions not previously collected.
• Penalties for failing to file and pay payroll taxes.
• Additional fines for missing unemployment and workers’ compensation insurance payments.
• Legal costs arising from employee claims related to insurance and benefits, overtime pay, and workplace protections.

Moreover, employees who believe they have been misclassified can report the employer to the IRS using Form SS-8. The IRS considers such cases carefully, and a finding of misclassification can trigger broader audits across a company’s workforce.

Assessment Tools and IRS Support

To aid business owners, the IRS offers several resources. Employers uncertain about how to classify workers may request an official determination by submitting Form SS-8, “Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.” While awaiting a response, businesses are encouraged to consult legal and tax professionals who specialize in labor and employment law to minimize risk.

The Growing Complexity of Worker Arrangements

Modern business trends, particularly the rise of the gig economy and remote work, have made worker classification even more complex. Job functions that previously were easy to categorize now span multiple locations, flexible hours, and digital platforms. The IRS, Department of Labor (DOL), and state regulators continue to update and clarify rules, but business owners must remain vigilant.

For example, many gig workers—such as drivers for rideshare or delivery companies—are often classified as independent contractors. Some states, such as California, have developed more rigorous multi-factor tests, such as the “ABC test,” to determine employment status. Conflicts between state and federal interpretations can make compliance daunting for companies operating nationwide^{[web:2][web:3]}.

Practical Steps for Employers

Business owners can take several steps to safeguard against misclassification:

• Carefully Review IRS Guidelines: Study the IRS’s three-factor control test and keep abreast of changes in regulatory interpretations.
• Document Worker Arrangements: Create clear contracts that reflect the actual working relationship and adhere to IRS standards.
• Limit Employer Control: Avoid directing independent contractors on when, where, and how to perform their work. Allow flexibility, and avoid using company equipment when possible.
• Consult Legal Counsel: Engage attorneys specializing in employment and tax law before hiring, establishing contracts, or making classification decisions.
• Conduct Periodic Audits: Review worker classifications regularly, especially as roles and job descriptions evolve.
• Stay Informed: Monitor IRS bulletins, DOL updates, and state-level employment laws for changes that affect classification criteria.

Employee Protections and Contractor Limitations

Employees benefit from a host of federal and state protections denied to independent contractors. These include:

• Overtime and minimum wage protections under the Fair Labor Standards Act (FLSA).
• Eligibility for unemployment insurance and workers’ compensation.
• Anti-discrimination safeguards under the Civil Rights Act, Americans with Disabilities Act (ADA), and Age Discrimination in Employment Act (ADEA).
• Employer-sponsored health insurance, retirement plans, paid leave, and other benefits.

Independent contractors do not enjoy these protections. However, they typically set their own schedules, negotiate fees, assume profit and loss risks, and may perform work for multiple clients. Misclassifying employees deprives them of statutory rights and exposes businesses to liability and reputational damage.

Common Pitfalls and Red Flags

The following are common mistakes leading to misclassification:

• Assigning work hours and office space to independent contractors.
• Providing training, supervision, or company equipment.
• Restricting contractors from marketing their services to other clients.
• Misusing “contractor” titles—jobs requiring close supervision or ongoing need are likely to be classified as employee roles.

The IRS and courts focus on the actual nature of the relationship, not simply on contract language or job titles. It’s essential for employers to look beyond superficial labels and evaluate the full scope of the working arrangement^{[web:2][web:3]}.

Legal Counsel: The Small Business Owner’s Ally

Tax disputes around worker classification are complex, with potentially severe consequences. For this reason, business owners are strongly urged to engage legal and tax professionals before hiring. Attorneys can assess risk, prepare sound contracts, and provide representation should disputes arise. Furthermore, legal counsel is invaluable in resolving outstanding compliance issues and defending against audits—an ounce of prevention is worth far more than millions in penalties^{[web:1][web:2][web:3]}.

Conclusion

Worker classification is a foundational element of business compliance and success. Misclassification risks can threaten even large employers, as demonstrated by FedEx’s costly settlement^[web:1]. By understanding the IRS’s standards, regularly reviewing worker arrangements, keeping documentation robust, and seeking expert advice, business owners can minimize exposure to fines and lawsuits. In a rapidly changing economic landscape, the prudent approach is to remain informed and proactive, treating proper worker classification not as an option, but as an essential business practice.