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Worker Classification Audit: How the IRS Decides Employee vs Contractor, and What Reclassification Costs
Updated
The IRS does not care what you called the worker. It applies a three-part common law test to the actual relationship, and if it decides your contractors were employees, the withholding you never took and the matching tax you never paid become a balance on your account. This page is about how that test works and what to do when the IRS is applying it to you.
The short answer: in a worker classification audit the IRS examines whether people you paid as independent contractors were really employees. It says you must consider all evidence of the degree of control and independence, in three categories: behavioral control, financial control, and the relationship of the parties. There is no set number of factors and no single factor decides it. If a worker is an employee, the IRS says you must withhold and deposit income, Social Security and Medicare taxes, pay the matching employer share, and pay unemployment tax.
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What the audit is actually asking
The IRS's page on the subject opens with the instruction: it is critical that business owners correctly determine whether the individuals providing services are employees or independent contractors. Then it explains why the answer matters. For an employee, you generally must withhold and deposit income taxes, Social Security taxes and Medicare taxes from wages, pay the matching employer portion of Social Security and Medicare, and pay unemployment tax on the wages. For an independent contractor, you generally do not have to withhold or pay any taxes on the payments.
A worker classification audit is the IRS testing whether the second description was true for the people you paid on a 1099. If it decides they were employees, every one of those obligations existed for every pay period, and the balance that results is an employment tax debt with the same character as any other. The IRS's guidance is on its independent contractor or employee page and in Topic 762.
The three-part test, in the IRS's words
The IRS says the facts that provide evidence of the degree of control and independence fall into three categories, and Topic 762 spells out what each one covers.
- Behavioral control. Facts that show whether the business has a right to direct and control what work is accomplished and how it is done, through instructions, training or other means. The question is whether you control, or have the right to control, what the worker does and how.
- Financial control. Facts that show whether the business has a right to direct or control the financial and business aspects of the worker's job: the extent of the worker's unreimbursed business expenses, the worker's investment in the facilities or tools used, the extent to which the worker makes services available to the market, how the business pays the worker, and whether the worker can realize a profit or incur a loss.
- Relationship of the parties. Written contracts or oral agreements describing the relationship the parties intended, whether the business provides employee-type benefits such as insurance, a pension plan, vacation pay or sick pay, the permanency of the relationship, and the extent to which the services performed are a key aspect of the regular business.
Then the sentence that decides most audits: there is no magic or set number of factors that makes the worker an employee or an independent contractor, and no one factor stands alone. Factors relevant in one situation may not be relevant in another. The IRS says the key is to look at the entire relationship, consider the extent of the right to direct and control, and document each of the factors used in coming to the determination.
Two things the IRS says that surprise business owners
First, the contract does not settle it. A written agreement calling someone a contractor is one fact under the relationship category. It does not outweigh the behavioral and financial facts if those point the other way. A person with a contractor agreement who works set hours, uses your equipment, is paid hourly, does the core work of the business and has done so for years is, on the IRS's own list, showing most of the marks of an employee.
Second, remote does not mean contractor. The IRS says that an individual working remotely, performing services from a location other than an office you operate, is your employee under the common law rules if you can control what will be done and how it will be done, and that this is so even if the worker can choose to work remotely. What matters is the right to control the details of how the services are performed.
What reclassification costs
If the IRS reclassifies a worker, the obligations it lists for employees apply to the wages you paid. That is the income tax that should have been withheld, both halves of Social Security and Medicare, and federal unemployment tax, for the periods under audit, with penalties and interest on top. For a business with several workers over several years the number gets large quickly, and the withheld portion of it becomes trust fund money, which is the part the IRS can pursue personally. Our 941 payroll tax debt and trust fund recovery penalty pages explain that exposure.
The IRS's Topic 762 also names two programs. Form SS-8 lets you, or a worker, ask the IRS to determine a specific individual's status. And the Voluntary Classification Settlement Program is described as a voluntary program to reclassify your workers as employees with partial relief from federal employment taxes. Whether either fits depends on whether an audit has already begun and what the facts look like, and neither is a decision to make without knowing the exposure first.
What Clarity does in a classification audit
We do the exercise the IRS says it does, worker by worker, before the IRS does it to you. For each person the audit covers we build the record against the three categories: who set the hours, who supplied the tools, how they were paid, whether they had other clients, whether there was a contract, how long it went on, whether the work was the core of the business. That record is what the audit turns on, and the IRS itself says to document each factor.
- We separate the workers. Audits often cover everyone paid on a 1099, and the facts differ. A genuine outside specialist and a full-time crew member on a 1099 are not the same case, and treating them as one concedes the strong ones.
- We quantify the exposure for the workers who will not hold up, so the negotiation is about a real number.
- We evaluate the settlement routes, including the voluntary program the IRS names, against the facts and the audit's stage.
- We handle the examiner under a power of attorney, and we resolve any resulting balance as an employment tax matter, on a plan the business can carry.
The investigation fee is $495 for an individual and $695 for a business. For a classification matter it covers the transcript pull, a worker-by-worker exposure review and a written plan, and it comes with a 15-day money-back policy from the date you sign. You have the written agreement before anything is charged.
The hard part, stated plainly
The hard part is that the IRS's test measures what actually happened, and most businesses that lose these audits did not lie about anything. They hired people the way everyone in their trade hires people, called them contractors because that is what the trade calls them, and controlled their work because that is how the work gets done. The IRS's own list of factors describes that arrangement as employment, and the contract does not change it.
The second hard part is that the cost is retroactive. Reclassification does not start on the day of the decision. It reaches back through the periods audited, and the withheld share of it can follow the owner personally.
When you do not need anyone
If the workers in question genuinely ran their own businesses, set their own hours, used their own tools, invoiced you among other clients and could have made or lost money on the job, the IRS's factors point your way and the record probably speaks for itself. Gather it and present it. If you have already decided the workers should be employees and no audit has begun, the voluntary program the IRS names is something you can read about and apply for directly.
Where a review earns its fee: an audit letter has arrived, the workers did the core work of the business on your schedule, several years are involved, the potential balance is large, or the same people also appear in a payroll tax problem. Those are the cases where the worker-by-worker record and the exposure math change the outcome.
Worker Classification Audit Questions, Answered
What is a worker classification audit?
It is an IRS examination of whether people you paid as independent contractors were really employees. The IRS says you must consider all evidence of the degree of control and independence in the relationship, in three categories: behavioral control, financial control, and the relationship of the parties. If the IRS reclassifies a worker, the employment taxes that apply to employees apply to the wages you paid.
How does the IRS decide if someone is an employee or a contractor?
By examining the entire relationship. The IRS says the evidence falls into behavioral control, financial control and the relationship of the parties, that there is no magic or set number of factors, that no one factor stands alone, and that factors relevant in one situation may not be relevant in another. It says to consider the extent of the right to direct and control the worker, and to document each factor used.
Does a signed contractor agreement protect me?
Not by itself. The IRS lists written contracts describing the intended relationship as one fact under the relationship-of-the-parties category. It is weighed alongside the behavioral and financial facts, and it does not outweigh them if the business controlled what was done and how, supplied the tools, paid by the hour and treated the work as a key part of its regular business.
Are remote workers automatically independent contractors?
No. The IRS says an individual working remotely, from a location other than an office you operate, is your employee under the common law rules if you can control what will be done and how it will be done, and that this is so even if the worker chooses to work remotely. What matters is the right to control the details of how the services are performed.
What happens if the IRS reclassifies my contractors as employees?
The IRS says that for an employee you must withhold and deposit income taxes, Social Security and Medicare taxes, pay the matching employer portion, and pay unemployment tax. On reclassification those obligations apply to the wages already paid for the periods examined, with penalties and interest, and the withheld portion becomes trust fund money the IRS can pursue personally.
Can I ask the IRS to decide a worker's status in advance?
Yes. The IRS says that if you want it to determine whether a specific individual is an independent contractor or an employee, you file Form SS-8, Determination of Worker Status. It also describes the Voluntary Classification Settlement Program as a voluntary program to reclassify workers as employees with partial relief from federal employment taxes.
Results vary based on individual facts and circumstances. Whether a worker is an employee depends on the whole relationship, and no specific outcome is guaranteed. This page is general information about IRS worker classification audits, not tax or legal advice.
Related Services: 941 Payroll Tax Debt · Trust Fund Recovery Penalty · IRS Audit Representation · IRS Payment Plans · or return to All Tax Relief Services.
The three categories the IRS weighs, and the facts in each
| Category | What the IRS says it covers |
|---|---|
| Behavioral control | Whether the business has a right to direct and control what work is accomplished and how it is done, through instructions, training or other means. |
| Financial control | The worker's unreimbursed business expenses, investment in facilities or tools, availability of services to the market, how the business pays the worker, and whether the worker can realize a profit or incur a loss. |
| Relationship of the parties | Written contracts or oral agreements describing the intended relationship, employee-type benefits such as insurance, a pension plan, vacation or sick pay, the permanency of the relationship, and whether the services are a key aspect of the regular business. |
| How they combine | No magic or set number of factors makes a worker an employee or a contractor, no one factor stands alone, and the whole relationship is considered. Document each factor used. |
Figures from IRS, Topic no. 762, Independent contractor vs. employee · IRS, Independent contractor (self-employed) or employee?.
“There is no "magic" or set number of factors that "makes" the worker an employee or an independent contractor and no one factor stands alone in making this determination.”
— IRS, Independent contractor (self-employed) or employee?
The passage quoted above is from IRS, Independent contractor (self-employed) or employee?.