Misclassifying employees and contractors can have serious ramifications, including tax penalties and lawsuits.  Make sure you know the differences, withhold appropriate taxes for employees and report income on both state and federal levels.

Understanding the difference between employees and contractors can defined in three categories; Behavioral Control, Financial Control and Relationship.

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If the business has the right to direct and control the work performed, regardless of whether they do or not, then the worker is an employee.  This involves things such as when and where to work, what tools are used, give detailed instructions or training on how to perform the work, and evaluate the work performed.

If the business is the one who controls the equipment used to perform the work and pays on an hourly, weekly or other period method the worker is usually an employee.

If the business has a contract of employment, provides employee-type benefits (insurance, pension, vacation, sick time), the work is a key activity of the business, and the relationship is more permanent based, then the worker is generally an employee.

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If the business does not maintain the right to direct or control the work performed, does not give detailed instruction or training on how the work is performed and does not dictate when and where to work outside of generalities, then the worker is usually a contractor.

If the worker controls the equipment used to perform work, gets paid based on the work performed, incurs reimbursable expenses, is free to other business opportunities and has the opportunity for profit or loss, the worker is very likely an independent contractor.

If the relationship is temporary in nature, the worker does not receive employee-type benefits, provides a service for the business but is not the key activity of the business, and pay is based on a contract, the worker is generally considered a contractor.

Tax Filing and Reporting:

If the worker’s status is an employee, the business should obtain a W-4, I-9 Employment Eligibility Verification, State Tax withholding at minimum.  Most businesses today pay via Direct Deposit, so be sure to obtain a Direct Deposit form as well.  Social Security Numbers can be E-verified for employment eligibility in the U.S.

Employers should withhold taxes both federal, state and local income taxes, social security taxes, medicare and pay unemployment tax as appropriate for their local tax laws.  Withholdings are then reported and paid on a monthly or quarterly basis.

Businesses are also required to obtain a W-9 form for all contractors and report total annual payments made on form 1099-NEC (Non-employee Compensation) by January 30th each year.  

Businesses are not required to withhold taxes from contractors unless a W-9 is not obtained in the manner required by the IRS.  In those cases, the business should backup withhold based on the rate required by the IRS.  Some contractors may be exempt from the backup withholdings, such as a corporation.  For more information see: https://www.irs.gov/instructions/iw9 under Payees Exempt From Backup Withholding.


Misclassifying an employee as an independent contractor can result in liability of employment taxes, possible penalties and in some cases result in lawsuits.

Make certain that you know the differences and classify accordingly to avoid costly and possible legal complications.