Do you hire employees or do you label some or all of your workers as independent contractors?

The distinction is important--and if you misclassify employees as ICs, the IRS can impose fines and penalties and even require you to pay payroll taxes retroactively. The agency takes this issue seriously because it claims to lose millions of dollars in tax revenue yearly because businesses wrongly classify contractors and employees.

Business owners like to classify workers as independent contractors because it's cheaper to do so. Among other economic benefits, you don't pay payroll taxes for ICs.

So, can you label any of your workers as ICs? Don't assume that where the work is done matters, because it doesn't. If it did, telecommuters could be misclassified as independent contractors, while a plumber hired to fix a leaky pipe might be misclassified as an employee.

Because work scenarios differ widely, classifications must be determined on a case-by-case basis. Make sure you view the topic the way the IRS will.

The operative word is independent. That's the big difference between contractors and employees. Just how independent is your worker from your company? Some guidelines are below; you should also see what the IRS says at

  • Employees (whether full- or part-time) are under their employers' direct control. The employer sets compensation, the work schedule, designates the location of workplace, provides all tools and supplies, and may require workers to track their time. Non-cash benefits, such as group health insurance and retirement savings plans, are typically made available. And employees who are terminated can collect unemployment benefits.
  • By contrast, independent contractors aren't under an employer's direct control. They negotiate their pay, set their own schedules, provide invoices for their services on their own letterheads, often work for other customers, use their own supplies, may get reimbursed for expenses and usually work on a project-by-project basis rather than for an indefinite period. They don't get non-cash benefits, and when their work is done they don't qualify for unemployment benefits.

If you want to increase the likelihood that the IRS will agree that your ICs truly are not employees, do this:

  • Hire contractors who have incorporated their businesses.
  • Sign a written contract clearly defining the contractor's services and compensation.
  • Obtain references or testimonials from other customers. This can help demonstrate his/her independent status.
  • Don't offer the contractor any of the employee benefits that your employees receive.
  • Keep copies of contracts, invoices, business cards, letterheads and other evidence to show the IRS if an agent questions your decision.

If you call any of workers ICs, and the IRS tries to reclassify them as employees, you can appeal. You'll have to provide documentation, so follow the above tips to improve your chances of convincing the IRS that you're right.