Question: We are currently downsizing as part of our company reorganization and are considering redesignating some of our employees as independent contractors. Are there any potential ramifications for making the change?
Answer: It is possible to change a worker's status from employee to independent contractor provided the worker meets the legal requirements for independent-contractor status. Whether a worker is an employee or an independent contractor is determined through legal tests established by state and federal courts and agencies.
For federal tax purposes, the IRS applies common-law rules that examine facts about the degree of direction and control the employer has and the amount of independence the worker has in performing the work. The more direction and control the employer exerts, the more likely the worker will be considered an employee; the more independent the worker is, the more likely the worker will be considered an independent contractor.
There is no single determinative factor; the determination is based on the totality of the circumstances. While other state and federal tests exist, most focus on substantially the same concepts of control, independence, and the economic relationship between the worker and the business.
The U.S. Department of Labor and federal courts often use an economic-realities approach when evaluating whether a worker is an employee under wage-and-hour laws, and enforcement of misclassification is a priority for regulators.
Employee misclassification is a major enforcement area because employees are entitled to protections and benefits not required for independent contractors, including minimum wage, overtime, family and medical leave, anti‑discrimination protections, unemployment insurance, workers' compensation, and employer contributions to payroll taxes.
By misclassifying workers, employers may deny individuals access to these protections and may avoid withholding income tax and paying employer payroll taxes and insurance contributions.
Investigations by wage‑and‑hour or tax authorities can be comprehensive; agencies often review classifications and payments for multiple workers over prior years.
Ramifications vary depending on whether an agency determines the misclassification was unintentional or intentional. For example, under the Fair Labor Standards Act employers may face back wages, liquidated damages, and litigation costs.
Potential federal tax penalties
- $50 for each required Form W-2 not filed because a worker was classified as an independent contractor.
- Penalties for failure to withhold, including a percentage of wages and assessments related to unwithheld FICA (Social Security and Medicare) taxes, plus interest.
- A failure-to-pay penalty of 0.5 percent of the unpaid tax per month, up to 25 percent of the liability.
- $50 for each failure to obtain a required Social Security number for a worker.
If an agency suspects fraud or intentional misconduct, higher fines, additional penalties, and even criminal penalties may apply, and responsible individuals can be held personally liable for uncollected taxes.
Employers should also be aware that states may impose their own payroll, tax, and civil penalties for misclassification; some states add interest and statutory fines and may pursue misdemeanor or other enforcement actions.
Because classification can be complex and the penalties significant, many employers review guidance and best practices before making changes; for practical guidance on classifying contractors, see Understanding Independent Contractors for Small Businesses.
For information about hiring risks, benefits, and related ownership considerations, see Independent Contractors: Hiring, Risks, Benefits, and IP Ownership.
When unsure about particular workers, employers are strongly encouraged to seek professional advice and to talk to your agent about insurance and liability concerns related to classification decisions.
Frequently Asked Questions
How do agencies decide whether someone is an employee or an independent contractor?
Agencies apply multi-factor tests that examine control, independence, and the economic relationship; no single factor is dispositive.
What protections might be denied if a worker is misclassified?
A misclassified worker may be denied minimum wage, overtime, unemployment benefits, workers' compensation, and other employment protections.
What are common consequences for employers who misclassify workers?
Employers may owe back wages, payroll taxes, interest, penalties, and possibly liquidated damages or additional fines for intentional misconduct.
Should I change a worker’s status solely to reduce payroll costs?
No; reclassifying primarily to cut costs increases legal and financial risk, and classification should be based on the actual working relationship.