One of the most common — and costly — mistakes small businesses make is misclassifying workers as independent contractors instead of employees. At first glance, paying someone as a contractor can seem easier: fewer payroll taxes, no benefits, and less paperwork. But if the IRS later decides that worker should have been treated as an employee, you could face years of back taxes, penalties, and interest — and possibly a Trust Fund Recovery Penalty. Understanding the IRS’s classification rules is essential to protect your business from audits and liabilities.
Why Worker Classification Matters?
Your worker classification determines:
- How you report income (Form W-2 vs. Form 1099-NEC)
- Who pays employment taxes (you or the worker)
- Eligibility for benefits and protections (workers’ comp, unemployment, overtime)
📘 Reference: Understanding Employee vs. Contractor — IRS
Employee vs. Independent Contractor: The IRS Test
The IRS evaluates three categories of control to decide whether a worker is an employee or an independent contractor:
| Control Category | IRS Focus | Meaning |
|---|---|---|
| Behavioral Control | Does the business control how the work is done? | This category examines whether the company controls what the worker does and how they do their job. |
| Financial Control | Does the business control the worker’s finances? | This category considers whether the business controls the financial aspects (i.e., reimbursed for expenses, etc.) of the worker’s job. |
| Relationship of the Parties | How do both parties perceive the relationship? | This category considers how the business and the worker perceive their relationship. |
Ways to Properly Classify Workers
Apply the IRS Three-Factor Test
Use the behavioral, financial, and relationship factors to categorize each role.
File the Correct Tax Forms
File correct tax forms for employees and independent contractors.
Correct Misclassifications Voluntarily
If you discover misclassifications, the IRS offers a way to fix them before penalties apply — the Voluntary Classification Settlement Program (VCSP).
📘 Reference: Voluntary Classification Settlement Program — IRS
Keep Documentation and Agreements Updated
Maintain the following information:
- Written contracts defining independent status.
- Proof of contractor’s business (EIN, business license, invoices).
- Copies of all tax forms.
Why Legal Representation Matters in Worker Classification Cases?
A tax attorney can:
- Analyze your worker relationships and prepare legal classification memoranda.
- Communicate directly with the IRS on your behalf (Form 2848).
- Defend against TFRP or employment tax assessments.
💡 Advantage: With representation, you gain attorney-client privilege — protecting confidential internal assessments from disclosure.
📘 References: Form 2848 — Power of Attorney and Declaration of Representative
Need help with a similar issue? Contact our firm today for a consultation.
Worker classification is not just a payroll decision — it’s a legal determination with major tax implications.
Getting it wrong can expose your business to audits, penalties, and even personal liability. If you’re unsure how to classify your workers, or if you’ve already received a classification audit notice, contact Pelham PLLC today.
FAQs
Can I fix past misclassifications?
Yes. Acting before the IRS contacts you can significantly reduce liability.
