Navigating worker classification: Your guide to legal, tax, and deal impacts

Classifying workers as either employees or independent contractors is a crucial decision for businesses, impacting tax obligations and legal and financial responsibilities. Misclassifying workers can result in substantial payroll taxes and penalties, underscoring the importance of understanding the differences between these two classifications. Determining whether a worker is classified as an employee or an independent contractor is highly fact-specific and requires a detailed examination of the individual’s role and responsibilities. Decisions shouldn’t be made hastily or without thorough analysis and documentation, as these serve as critical safeguards against misclassification risks. That importance is amplified when a business is involved in a sale transaction, since a buyer will scrutinize meaningful positions. Misclassification can raise red flags, leading to potential consequences for sellers. For instance, buyers may respond by demanding purchase price reductions, escrows, and indemnifications to address perceived risks and to protect against discovered liabilities.

Employment tax exposure is commonly known to impact buyers in an equity transaction. This exposure can also have an impact on asset purchases. Additionally, any person responsible for collecting and remitting withheld income and employment taxes (including officers and those with check-signing authority) may be held personally liable for the federal Trust Fund Recovery Penalty and any equivalent state laws based upon this failure. This exposure may become a relevant consideration when worker misclassification arises, and the misclassification is willful.

Here are a few considerations for businesses when navigating the complexities of worker classification, whether they’re acquiring, running, or selling a business.

Overview of employee vs. independent contractor

The determination of whether a service provider is properly classified as an independent contractor or an employee for federal tax purposes is based on the common law. Fortunately, classification for federal tax purposes is often similar to the classification for other purposes, including pension and profit-sharing, insurance and other benefits, unemployment compensation, minimum wage and overtime laws, and workers’ compensation. As such, classification errors may have consequences that extend beyond federal tax considerations. This article will focus on the federal tax classification of service providers. A more detailed discussion of the classification factors is discussed below, but the following definitions provide a general overview.

Independent contractor

Simply put, independent contractor status is often described as occurring when a service provider controls the “manner and means of employment.” The service recipient dictates the goals of the service but not the methods used to achieve it. Independent contractors often have the freedom to set their own schedules, determine their work processes, and may provide their own tools and materials.

• Federal tax information reporting: Businesses must issue Form 1099-NEC if individual contractors earn $600 or more.
• Federal employment tax payment obligations: Independent contractors are responsible for paying both the employee and employer portions of Social Security and Medicare taxes through self-employment taxes.

Employee

As a corollary, an employee is an individual who’s often described as controlling the manner and means of employment. Even where service providers have some flexibility in their work, the employer retains the right to direct the way the job is performed. Employees are typically subject to more rules and oversight compared to independent contractors.

• Federal tax information reporting: Employers must issue Form W-2 at the end of the year.
• Federal employment tax payment obligations: Employers are responsible for withholding and remitting employment taxes, including Social Security, Medicare, state unemployment tax, and federal unemployment tax.

Independent contractors: Risks and misclassification

In recent years, the freelance economy has led more businesses to classify service providers as independent contractors. While independent contractor classification may offer businesses significant cost savings, by avoiding expenses such as taxes, employment benefits, and overtime pay, there are serious risks if the worker is misclassified as an independent contractor.

Businesses who misclassify workers face a range of potential liabilities, including:

• Employment taxes.
• Unpaid wages, such as overtime and minimum wages.
• Unemployment insurance claims.
• Workers’ compensation claims.
• Violations of the Family and Medical Leave Act (FMLA).
• Claims involving benefits like health insurance or retirement plans.
• Interest and penalties on amounts described above.

Illustrating the potential tax exposure

To demonstrate the magnitude of misclassification risk, consider an example based on $100,000 of annual wages over three years. If a worker is incorrectly classified as an independent contractor instead of an employee, the cumulative employment tax liabilities of $135,900, excluding interest and penalties, would be due. As shown in the table below, these amounts add up quickly across multiple years, underscoring why accurate classification and proactive compliance are critical for businesses.

In particular, the Department of Labor (DOL) and the Internal Revenue Service (IRS) have been diligent in monitoring and auditing businesses for compliance with proper worker classification. Misclassification lawsuits, like class-action suits, can result in significant financial and reputational damages.

Misclassifying key workers can create some other consequences that disrupt a business following an acquisition. For example, if the seller treated a key person like a top salesperson or vice president as an independent contractor before an acquisition, and then the buyer later reclassifies them as an employee, the buyer may reduce the worker’s pay to account for additional taxes payable by the company and reduce the provision of benefits — particularly insurance and other benefits — to the disappointment of the worker, who may choose to discontinue employment. Losing critical talent after a deal can disrupt operations, slow down integration, and affect business performance, especially if the person played a major role in generating revenue or managing client relationships. All of these risks can ultimately reduce the value of the acquisition and make post-deal execution more difficult.

Factors in determining classification

Because classification depends upon various factors — for simplicity, we introduced the topic above through the lens of who controls the “manner and means of employment.” In fact, for federal tax purposes, the IRS looks at 20 different factors grouped into three key areas based on common law rules, listed in Rev. Rul. 87-41. The IRS provides an overview in Publication 15-A (2025), Employer’s Supplemental Tax Guide that highlights these three areas:

1. Behavioral control. This factor looks at whether the employer has the right to control how the work is performed. Key elements to consider include:
   • Types of instructions given. Does the employer provide specific guidance on how the work should be performed, or does the worker have the freedom to decide?
   • Degree of instruction. How detailed are the instructions provided? The more detailed the instructions, the more likely the worker is an employee.
   • Training. Does the employer provide formal training to the worker on how to do the job, or does the worker already have the necessary skills?
2. Financial control. This factor focuses on whether the employer controls the economic aspects of the worker’s job, including:
   • Significant investment. Does the worker invest in their own tools or equipment, or are they provided by the employer?
   • Unreimbursed expenses. Are the workers’ expenses reimbursed, or does the worker cover their costs themselves?
   • Opportunity for profit or loss. Does the worker have a chance to earn a profit or incur a loss based on their performance, or are they paid a fixed salary or hourly wage?
   • Services available to the market. Does the worker offer services to multiple clients, or are they working exclusively for one employer?
3. Type of relationship. This refers to how the business and worker perceive their relationship. Key elements include:
   • Written contracts. Does the business have a formal contract outlining the terms of the relationship?
   • Employee benefits. Does the worker receive benefits such as health insurance, retirement plans, or paid time off?
   • Permanency of the relationship. Is the relationship expected to be long term or temporary in nature?
   • Core services of the business. Does the worker provide services that are essential to the core business activities?

The location of the work is irrelevant — remote services are governed by the same test as in-person work.

Businesses can use these factors to help ensure they’re classifying workers correctly and avoiding misclassification risks. The factors also provide a roadmap for businesses that wish to restructure their employment relationships.

Safeguarding against misclassification risks

Reducing the risks associated with misclassification won’t be effective or easy with a “wait and see” approach. Businesses can implement several strategies to stay a step ahead.

• Develop and implement policies: Create and implement policies to clarify who, when, and how independent contractors may be engaged, focusing on proper classification. Companies that have such policies are less likely to misclassify service providers, and the existence of such policies are often available to mitigate negative misclassification consequences.
• Training: Ensure all persons responsible for employment and supervision are properly trained on the policy and best practices for working with independent contractors. Proper training can assist those charged with oversight to ensure that workers are classified properly, and when reclassification should occur based on a change in duties or other factors.
• Review engagements: Implement a process to monitor and evaluate independent contractor engagements, especially if they have been with the company for over a year. Service providers who are misclassified for greater periods of time present greater negative consequences.
• Standard independent contractor agreement: Draft and use standardized agreements that clearly define the nature of the relationship. While courts and the IRS won’t classify a service provider solely on the agreement between the service provider and recipient, the existence of an agreement is a consideration — and the agreement of the parties may be considered a mitigating circumstance in some instances.
• Engage professionals to assist with classification decisions: The IRS and courts make classification decisions based on various factors and precedent often contained in cases and prior IRS administrative guidance. Industry practice is also a consideration. Engaging accountants and attorneys familiar with classification can assist with reaching proper decisions and may be a mitigating factor should penalties become a relevant consideration.
• Seeking the view of the IRS: Workers and employers may file Form SS-8 with the IRS, permitting the IRS to make a decision, which may be either binding or nonbinding (depending on the decision of the IRS). Obtaining the view of the IRS assists businesses in obtaining certainty with respect to classification.

Relief options available in the event of misclassification

The IRS offers several programs to help businesses reduce penalties and tax liabilities resulting from misclassifying employees as independent contractors. Each program has specific eligibility requirements that must be met to qualify:

• Section 530 protects businesses from retroactive employment tax liabilities if workers were consistently treated as contractors and all required filings were made.
• Section 3509 offers reduced employment tax rates when misclassification was unintentional and not due to willful disregard of tax rules, helping to limit penalties.
• Section 3402(d) further reduces the employer’s liability if the misclassified worker has already paid their income taxes, easing the burden on the business.
• Voluntary Classification Settlement Program (VCSP) allows businesses to voluntarily reclassify workers as employees for future tax periods. If eligible, businesses can benefit from significantly reduced penalties and avoid audits related to past misclassifications.

What should businesses do now?

Given the complexity of worker classification, businesses must carefully assess their relationships with workers using the common law rules outlined above: behavioral control, financial control, and the nature of the relationship. Early consultations with tax advisors and legal counsel can help businesses navigate the ins and outs of worker misclassification and proactively address potential issues to protect the deal.