How Small Businesses Should Classify Workers for Tax Purposes

Worker classification affects both a company’s tax duties and a worker’s financial responsibilities. Employees generally receive closer direction about how their jobs are performed, while contractors usually have more freedom over their methods and schedules, provided they complete the assignment. Contractors may gain flexibility, but they typically do not receive benefits such as health coverage or retirement plans and must handle more records and tax work themselves.

Businesses can reduce certain costs when they properly use contractors. They generally do not pay federal or state unemployment insurance for those workers, collect their Social Security and Medicare payroll taxes, or pay the employer share of those taxes. But classification cannot be based on one detail or a simple checklist. The Labor Department and IRS examine the full relationship, including behavioral control, financial control, and the nature of the arrangement. A company’s right to direct the work can matter even when it does not actively give instructions.

When a business pays a properly classified contractor $600 or more during a calendar year, it must send Form 1099-NEC by January 31 of the following year. The contractor reports that income on a tax return. Businesses are responsible for weighing the relevant facts and documenting how they reached their decision.