One of the biggest questions business owners face is: Should I classify this worker as an employee or as an independent contractor? The answer matters—a lot—because getting it wrong can trigger tax problems, penalties, and even lawsuits.
The IRS Common Law Rules are the framework used to make that call. Unlike job titles or contracts, what really counts is the actual relationship between the business and the worker.
Why classification matters
Employees and contractors are treated very differently under the law:
- Employees: You must withhold income taxes, pay Social Security and Medicare (FICA), provide unemployment insurance, and often comply with wage and hour laws like the FLSA.
- Independent contractors: They handle their own taxes and benefits. You simply pay them the agreed amount and issue a 1099 form if they earn $600 or more.
Misclassifying workers can mean back taxes, penalties, and unpaid wages. That’s why the IRS uses common law rules to cut through the confusion.
The 3 key factors in the IRS Common Law Rules
The IRS looks at the degree of control and independence in the relationship, grouped into three main categories:
1. Behavioral control
- Does the business tell the worker when, where, and how to do the job?
- Are there required instructions, training, or supervision?
If yes, the worker looks more like an employee. Independent contractors typically control how they get the job done.
2. Financial control
- Who provides the tools, equipment, or supplies?
- Can the worker make a profit or suffer a loss?
- Is the worker paid a flat fee per project (contractor) or an hourly/salary wage (employee)?
Independent contractors usually invest in their own tools and have more risk/reward.
3. Type of relationship
- Is there a written contract, and does it describe the worker as an independent contractor?
- Does the business provide benefits like insurance, paid time off, or retirement?
- Is the relationship ongoing, or project-by-project?
The more permanent and benefit-heavy the arrangement, the more likely the worker is an employee.
Examples to make it clearer
- Employee: A café hires a barista to work 30 hours a week on a set schedule, using the café’s equipment. The owner trains and supervises them.
- Independent contractor: A graphic designer works from home, sets their own hours, uses their own software, and is paid per completed project.
Common mistakes employers make
- Assuming a contract alone makes someone a contractor. (The IRS looks at reality, not paperwork.)
- Paying someone a flat weekly “salary” and calling them a contractor.
- Treating long-term, ongoing workers as contractors to avoid payroll taxes.
- Providing contractors with the same benefits and supervision as employees.
How to stay compliant
- Review your workforce – Apply the three IRS factors to every role.
- Use clear contracts – Spell out independence, scope, and payment terms.
- Avoid too much control – The more you direct the worker, the more they look like an employee.
- Reevaluate over time – Relationships can evolve from contractor to employee.
- File the right forms – W-2 for employees, 1099-NEC for contractors.
How Kubera HR Solutions can help
At Kubera HR Solutions, we help employers review and audit worker classifications to make sure employees and independent contractors are properly identified. Our audits help prevent costly IRS penalties, wage claims, and lawsuits. If you’re unsure about your classifications, our team can give you clarity and a compliance roadmap. Schedule a free consultation today!