A Brief Guide to Federal Employment Classifications

Understanding worker status is important to ensure you file the right tax forms with the IRS and avoid labor law issues that might put you or your business at risk.

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Whether you’re an employee or an independent contractor, it’s important to understand federal employment classifications. However, different government agencies may classify your employment status in varying ways. Both the IRS and the Department of Labor come at the issue with different purposes in mind.

IRS vs. Department of Labor Classifications

How are they different?

Both the IRS and the Department of Labor take the issue of federal employment classifications seriously. Both agencies want to encourage the proper classification of workers. But each agency has a different focus when approaching the question.

The IRS is interested in how worker status (independent contractor vs. employee) affects employers’ reporting and withholding obligations regarding employment and income tax. Employees are subject to employment taxes, but independent contractors are not.

The Department of Labor, on the other hand, is concerned about protecting employees via the Fair Labor Standards Act of 1938 (FLSA). This act establishes restrictions regarding work hours, minimum wage, child labor, overtime, and the like. These laws protect employees, but they do not apply to independent contractors.

IRS Federal Employment Classifications

The IRS insists that business owners and employers categorize their workers correctly as independent contractors vs. employees.

Independent Contractor vs. Employee

According to the IRS, an independent contractor is a worker who controls and directs how they do their own work. The person paying the independent contractor (who technically can’t be called an “employer”) can only control the result of the work. An independent contractor’s earnings are subject to self-employment tax.

The relationship between an employer and employee is different. If the person paying for the work can control both what is done and how it’s done, the worker is more likely to be classified as an employee. This is true even if the employee has significant freedom regarding their work.

Not all employees are full-time workers. Part-time workers may be employees. In addition, workers hired for a short duration such as days or weeks may also be employees.

However, federal employment classifications are not always cut and dried. To determine the proper classification, the IRS takes many factors into consideration.

The Three-Factor Test

The IRS uses three common law factors to determine whether a worker is an independent contractor vs. an employee. It considers behavioral control, financial control, and the relationship between the two parties. Any one of these factors can tilt the federal employment classification towards an “employee” designation. The IRS presumes that a worker is an employee, and the burden of proof is on the employer to prove otherwise.

Behavioral control: This factor looks at whether the company or the worker controls what the worker does and how they do it. Among the questions to consider here are:

  • Does the company instruct the worker where and when to work?
  • Does it tell the worker what tools, supplies, and services to use?
  • Does the company provide detailed task instructions?
  • Does it provide training, especially ongoing training?
  • Does the company evaluate how the worker does the job, rather than just evaluating results?

If the answer to these questions is “yes,” the worker is more likely to receive an employee designation from the IRS.

Financial control: The second factor looks at the degree of control a company exerts over how and when the worker is paid, who pays for equipment and supplies, and whether expenses are reimbursed. The higher degree of control, the more likely the worker receives an “employee” classification. Common questions to ask regarding financial control include:

  • Are the worker’s services available on the open market?
  • Does the company guarantee a wage for work done on an hourly or weekly basis?
  • Does the worker have an investment in their work equipment?
  • Are the worker’s expenses reimbursed?
  • Does the worker have the opportunity to profit from the work?

Independent contractors typically charge fees on a job-by-job basis, rather than being paid a wage. They also typically own their own tools and are able to work for multiple companies simultaneously.

Relationship between the parties: The IRS looks at a few other factors to determine federal employment classifications. Among the considerations here:

  • Does the worker receive benefits? (These might include paid vacations, a pension plan, sick leave, or health insurance.)
  • Does the worker provide services that are key to the business?
  • Does the worker have a continuing relationship with the business (as opposed to being hired for a specific project)?
  • Is there a written contract stating that the worker is an employee?

If the answers to these questions are all “yes,” the worker is almost certainly an employee, not an independent contractor.

In fact, no one factor determines the independent contractor vs. employee determination. Many workers are able to answer “yes” to some employee questions but not to others.

The 20-Factor Test

The three federal employment classification factors above are drawn from a list of 20 factors that the IRS used to rely on. While the IRS no longer officially uses these 20 factors, some states refer to them. They are:

  1. Level of instruction: Does the company tell the worker when, where, and how to do the work?
  2. Training: Does the company provide training?
  3. Business integration: Do the worker’s services affect the company’s business success?
  4. Personal services provided: Does the company control who performs what tasks?
  5. Hiring of assistants: Does the company supervise and pay for the worker’s assistants?
  6. Continuity of relationship: Do the company and worker have a continuous relationship?
  7. Schedule flexibility: Does the company dictate when the worker works?
  8. Full-time work: Does the worker provide services to the company on a full-time basis?
  9. On-site services: Does the worker have to work on the company’s premises?
  10. Work sequences: Does the company require work to be performed in a specific order?
  11. Reporting requirements: Does the worker have to provide status reports?
  12. Payment: Is the worker paid on an hourly, weekly, or monthly pay schedule?
  13. Expenses: Does the company pay for the worker’s business or travel expenses?
  14. Tools and supplies: Does the company supply the worker’s tools, equipment, and supplies?
  15. Work facilities: Does the company provide work facilities to the worker?
  16. Profit or loss: Does the worker receive predetermined earnings with no possibility for profit or loss?
  17. Work for multiple companies: Is the worker restricted to working only for the one company?
  18. Public availability: Is the worker restricted from making their services available to the public?
  19. Right to discharge: Does the company have a unilateral right to discharge the worker?
  20. Right to terminate: Does the company have the right to terminate the worker without liability?

If the answer to the questions above is “yes,” the worker involved is almost certainly an employee, not an independent contractor.

What can an employee do if they think they’re misclassified?

Sometimes workers are classified as independent contractors, but they think they’re employees. If you think you’ve been misclassified, file a report with the IRS. This allows you to try to collect the Social Security and Medicare taxes the company should have paid.

The IRS also offers a Voluntary Classification Settlement Program to help employers reclassify workers as employees. Employers who take advantage of this program may receive partial relief from their federal employment tax obligations.

Department of Labor Status

The Department of Labor’s interest in federal employment classifications focuses on the application of the FLSA. The agency wants to make sure that workers are treated fairly, whether independent contractor or employee.

Federal Law: The Fair Labor Standards Act

The FLSA protects workers in private business and governmental jobs by establishing standards that employers must meet. Among the standards set by the Department of Labor are:

  • Federal minimum wage. (Some states set higher minimum wages.)
  • Overtime for hours worked in excess of 40 per week
  • Number of hours worked per week or day
  • Child labor laws to protect minors

Independent Contractors vs. Employee

The factors the Department of Labor considers in determining the independent contractor vs. employee question overlap with those of the IRS. However, they’re not quite the same.

The Department of Labor’s federal employment classifications categorize workers as independent business owners or employees. The factors it considers in making the determination are:

  • The extent to which the worker’s services are integral to the company’s business
  • The permanent or temporary nature of the relationship
  • The amount the worker has invested in facilities and equipment
  • The degree and nature of control the company has over the worker
  • The worker’s opportunities for profit and loss
  • The amount of initiative required on the part of the worker
  • The degree to which the worker and company are independent in organization and operation

The Department of Labor does not consider the location of work to be relevant to the independent contractor vs. employee issue. In addition, the existence of an employment contract and the manner of pay are irrelevant to the Department of Labor.

Economic Reality Test

The FLSA tests the employer/employee relationship by looking at economic reality. In other words, an employee is someone who is dependent on the business where they work. An independent contractor is someone who is engaged in their own business.

One of the key factors in the economic reality test is the worker’s control of the work they do. The worker’s opportunity for profit or loss based on their own initiative is another factor in the economic reality test.

Other Factors in the Independent Contractor vs. Employee Test

If the economic reality test doesn’t help the Department of Labor determine workers’ federal employment classifications, it considers other factors. It looks at the amount of skill required for the work, as well as the degree of permanence of the work relationship. In addition, the Department of Labor considers whether the work done is integral to the business’s products or services.

Consequences for Failure to Properly Identify Workers

When employees are misclassified as independent contractors, the workers themselves reap negative consequences. They can be denied access to benefits they’re entitled to, including overtime, sick leave, unemployment insurance, a safe workplace, and other benefits. In addition, state and federal government and workers’ compensation funds can suffer from lower tax revenues.

The Department of Labor can hold employers liable for misclassification of workers. They may have to pay criminal penalties in addition to the back wages and benefits owed — not to mention the attorneys’ fees involved.

Employers may also be held liable at the federal level for:

  • Failure to file federal I-9 forms
  • Failure to meet anti-discrimination requirements
  • Violation of the Family and Medical Leave Act
  • Violation of the Uniformed Services Employment and Reemployment Rights Act

State Employment Classifications

Every state has a unique set of laws regarding the independent contractor vs. employee determination. Most states use some version of a three-factor test. In most cases, a worker must meet the following conditions to be considered an independent contractor:

  • The worker must do similar work on a regular basis for various other companies.
  • The work being done must be something outside the company’s usual course of business.
  • The worker must not be under the company’s control for the most part.

However, employment classification varies greatly from one state to the next. Check with your own state Department of Labor for specifics.

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Employment Classifications FAQ

  • Make sure you fill out IRS Form W-4, the Employee’s Withholding Certificate, when you begin your employment. Your employer will then arrange for taxes to be withheld from your paycheck.

  • Your employer will issue a W-2 for each tax year to help you file your own personal tax return.

  • Independent contractors should receive Form 1099 from each company they worked for during a given year. If you receive a significant amount or percentage of your yearly income as an independent contractor, you may be required to make estimated tax payments quarterly using IRS Form 1040-ES.

  • As an independent contractor, you should file Form 1040 every year. Attach Schedule C with your non-employment income. You also have to file Schedule SE, the Self-Employment Tax form, to pay your share of Social Security and Medicare taxes.

  • You may believe you are an employee when the company paying considers you an independent contractor. If so, file a report with the IRS. Use IRS Form 8919, Uncollected Social Security and Medicare Tax on Wages.

Disclaimer: The content on this page is for information purposes only and does not constitute legal, tax, or accounting advice. If you have specific questions about any of these topics, seek the counsel of a licensed professional.

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Written by Team ZenBusiness

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