Employee or Independent Contractor? Understanding Worker Classification and Year-End Reporting

Correctly classifying your workforce isn’t just about paperwork. It’s about protecting your business from compliance risks and costly missteps.

While there are guidelines in place to help determine whether someone is an employee or independent contractor, it’s not always a simple distinction. Misclassification can result in penalties, back taxes, and legal challenges, so it’s critical to evaluate the full scope of each working relationship.

Understanding the difference between an employee and an independent contractor ensures accurate tax reporting, reduces audit risk, and allows you to move forward confidently. We’ve outlined an assessment process to help you accurately determine whether a 1099 or a W-2 form is appropriate for your filing needs.

1099 or W-2? Understanding Your Reporting Obligations

At year-end, the way you classify your workers determines whether you issue:

• Form W-2: For employees — includes tax withholding, Social Security/Medicare contributions, and benefits reporting.
• Form 1099-NEC: For non-employees — typically used for independent contractors paid $600 or more in a calendar year.

Correct classification ensures you meet IRS requirements and provide workers with the appropriate documentation.

Types of Worker Classifications

Worker classifications go beyond employees or independent contractors. Here are the four main classifications for the people who perform services for your organization:

• Common-Law Employees: The key to common-law rules is control. If the organization can control what will be done (the results of the work) and how it will be done (the method by which the work is performed), then the person performing the services is the organization’s employee. It doesn’t matter under common-law rules what your title is or how your workers are classified. Managers, support staff, and supervisory personnel are all employees, while partners are not.
• Statutory Employees: There are special cases where a worker may not fit the traditional employee mold but is still treated as an employee for certain tax purposes. This includes:
  • A driver who distributes beverages (other than milk) or food (meat, vegetable, fruit, or bakery products), or who delivers dry cleaning if the driver is the organization’s agent or paid on commission.
  • A full-time life insurance sales agent who sells primarily for one life insurance company.
  • Someone who works at home on materials for an organization. The organization supplies the materials and materials must be returned to the organization if the organization furnishes specifics for the work to be done.
  • A full-time salesperson who works on behalf of an organization with wholesalers, retailers, contractors, or hotel operators, etc. as their primary business activity.

• Statutory Non-Employees: These individuals fall into three categories: direct sellers, licensed real estate agents, and certain companion sitters.
• Independent Contractors: An individual who provides services to another individual or business. They control how the work is performed, typically use their own tools, and are free to take on other clients.

How to Define an Independent Contractor

An important distinction between 1099 independent contractors vs. employees is that the former are, in fact, independent. But how do you really define independence versus control? The IRS uses three categories to help determine employee vs. 1099 contractor status:

Behavioral Control

Behavioral control refers to the right to direct or control how the worker performs a specific task. Specifically, this category looks at types of instruction given (what tools to use, when the work is to be performed, etc.), if there’s an evaluation system to measure details of performance, and if ongoing training is given. If these items are all present, it generally points toward an employee-employer relationship.

Financial Control

When it comes to financial control, the IRS looks at factors that point to control of the economic aspects of a worker’s activities.

Things to consider include:

• Significant investment: Has the individual made a significant investment in tools or facilities used to perform the task for your organization?
• Unreimbursed expenses: Has the individual chosen to incur expenses and bear the cost of the service provided for your organization?
• Services available to relevant markets: Does the individual make themselves available to other organizations or individuals similar to your organization?

If the answers to the above questions are yes, then you’re looking at an independent contractor relationship. Other items to note in this category include method of payment (hourly vs. flat fee for services) and opportunity for profit or loss (whether the individual is free to make business decisions affecting their own profit or loss).

Relationship of Parties

This category depends on how the worker and the business perceive each other in terms of intent concerning control. Here are some triggers:

• Intent of parties/written contracts: A written agreement or contract describing the worker as an independent contractor, methods of payment, expenses to be reimbursed, etc.
• Employee benefits: Providing a worker with benefits, including paid vacation or sick pay, health insurance, life insurance, etc.
• Regular business activity: Services performed by the individual are a key aspect of the regular business of the organization.

What If You’re Unsure?

If you find yourself second guessing if an individual is a W-2 employee or a 1099 independent contractor, there’s a special form known as Form SS-8. The IRS uses the information on that form, as well as any other information they can obtain from federal or state forms, to determine the status of the worker in question.

While Form SS-8 can help clarify a worker's status, it may initiate a formal review by the IRS — which can result in reclassification, back taxes, and penalties. It’s best used when the facts are unclear and both parties are uncertain about classification.

Protect Your Organization with Accurate Worker Classification

Clarifying the roles of independent contractors vs. employees is critical to determining the appropriate payment treatment and whether an individual requires a 1099 or a W-2 at year-end.

At Eide Bailly, we help you build compliant systems, protect your business from risk, and make confident decisions about the people who power your growth. Have questions about contractor vs. employee classification? Let’s talk.