Whether a worker is an employee or an independent contractor determines who pays FICA taxes, who withholds income tax, whether benefits are required, and how the worker deducts expenses. The classification is determined by the facts of the working relationship - not by what the parties call it or what the contract says. Misclassifying employees as contractors is one of the most common and costly payroll tax errors a business can make.
Employee (W-2): Employer withholds and pays half of FICA (7.65%), withholds income tax, issues W-2. Worker cannot deduct unreimbursed business expenses post-TCJA (through 2025). Worker participates in employer benefits.
Independent contractor (1099-NEC): Worker pays full self-employment tax (15.3% on net earnings). No employer withholding. Worker deducts business expenses on Schedule C. No employer benefits required. Worker is responsible for quarterly estimated payments.
The IRS applies a 20-factor test derived from Rev. Rul. 87-41, organized into three categories. No single factor is determinative - the totality of the relationship governs.
Behavioral control: Does the company control how the worker does the job - not just the result? Factors include: instructions given on when, where, and how to work; training provided; integration of the worker into the business. The more behavioral control, the more the worker looks like an employee.
Financial control: Does the business control the economic aspects of the worker's job? Factors: significant investment in tools and equipment by the worker (contractor indicator); opportunity for profit or loss; availability to work for other businesses; payment by the job rather than by the hour. A worker paid hourly with no investment in their own tools looks like an employee.
Type of relationship: How do the parties perceive the relationship? Written contracts, employee benefits (insurance, pension, vacation pay), permanency of the relationship, and whether the services are a key aspect of the company's regular business. A long-term, exclusive, benefits-receiving worker in the company's core business looks like an employee regardless of how the contract reads.
An employer who misclassifies employees as contractors owes: the employer's share of FICA (7.65% of wages), a portion of the employee's share of FICA (equal to 20% of the employee's share if no returns were filed), and a portion of income tax withholding. Under IRC §3509, reduced rates apply when the misclassification was not intentional and no returns were filed. Under §3402(d), intentional disregard of withholding obligations can result in the full withholding amount becoming due. State penalties are separate and can be severe - California in particular aggressively audits worker classification.
Section 530 of the Revenue Act of 1978 provides relief from employment tax liability for businesses that had a reasonable basis for treating workers as contractors. To qualify: the business must have filed all required 1099s, must not have treated any similar worker as an employee, and must have had a reasonable basis for the contractor treatment - such as reliance on a prior IRS audit, industry practice, or court decision. Section 530 relief is a defense against retroactive reclassification, not a license to misclassify going forward.