U.S. Payroll Practice Series: Worker Classification

Last Update: April 24, 2025

This article provides a comprehensive and practical overview of worker classification, an issue that no company doing business in the United States can afford to ignore. Worker classification is the process of determining whether a worker should be treated as an employee or an independent contractor. It is a foundational issue that affects tax, HR, labor and employment compliance, and legal risk.

In more contemporary terms, independent contcractors may include individuals commonly described as sole proprietors, freelancers, or digital nomads. In this article, however, we will use the term independent contractor throughout.

For companies expanding from Japan into the U.S. market, businesses that have just established a U.S. subsidiary, and professionals who have recently taken on HR or labor related responsibilities, this is both a critically important and often confusing area. The goal of this article is to ensure that, by the time readers finish it, they will be better equipped to make, document, explain, and address worker classification decisions in practice.

Explained clearly from the ground up, including key terminology and the policy background, so that even beginners can follow
Specifies the decision criteria, procedures, and documentation methods needed in practice
Presents the practical consequences of misclassification in concrete terms
Organizes the differences between federal law and the laws of key states, including New York, New Jersey, Texas, and California
Covers not only classification rules, but also procedures, document management, and internal compliance structure

Table of Contents

Why Worker Classification Matters and an Overview of the Two Categories

Why is worker classification so important?

Worker classification is not merely a formal administrative step. It is a critical determination that affects a company’s compliance framework, financial obligations, worker protections, and even the development of organizational culture. Misclassification can result in substantial back taxes, penalties, and interest, and in the worst case, it may lead to litigation and reputational damage.

Key practical implications

Differences in tax treatment: whether the company must withhold taxes, and whether it must issue a Form W-2 or Form 1099-NEC
Employer Payroll Taxとは、給与に関連して雇用主や従業員が負担する税金を指します。">payroll tax burden: whether the employer must pay its share of FICA taxes (Federal Insurance Contribution Act taxes for Social Security and Medicare)
Coverage under unemployment insurance and worker’s compensation
Applicability of federal and state employment laws: such as minimum wage, overtime, anti-discrimination protections, and leave requirements

Why do companies prefer to classify workers as independent contractors?

From the company’s perspective, treating a worker as an independent contractor can offer significant advantages. Common examples include:

No obligation to pay certain employment related taxes or insurance costs
Reduced administrative burden for tracking work hours, overtime, and related requirements
Greater flexibility to engage workers on a contract basis
A structure that works well for performance-based arrangements or short term projects

At the same time, however, this drive for cost savings and flexibility can create fertile ground for improper classification, or misclassification. For that reason, the IRS and the DOL have increased their enforcement efforts in this area in recent years. Enforcement actions have been especially common in industries such as technology, ride hailing, construction, and hospitality.

In many cases, worker classification is not clear cut

As business models and work arrangements have become more diverse, gray area classifications have become increasingly common.

Example include:

Remote workers, where the actual working relationship may be less visible
Individuals engaged only a few days a week on a contract basis
Engineers or consultants involved on a project basis

In these situations, classification cannot be determined solely by the contract label or job title. The decision must be based on the actual nature of the work and the reality of the working relationship. For that reason, this section will examine the relevant classification standards in detail.

Employee vs Independent Contractor: Key Differences in Tax, Benefits, and Legal Obligations

One of the main reasons worker classification matters is that an employer’s obligations can differ significantly depending on how a worker is classified. In this section, we will provide a structured comparison of employees and independent contractors under U.S. tax and employment law, organized by key compliance areas.

Tax Differences

For Employees

The employer must withhold federal income tax, Social Security tax, and Medicare tax^{1, 2}
FICA taxes are shared by the employer and the employee^{1, 2}
The employer must issue Form W-2 (“Wage and Tax Statement”) by the end of January of the following year^{3, 6}

For Independent Contractors

No tax withholding is generally required⁴
The independent contractor is responsible for reporting and paying the full self-employment tax under SECA (Self-Employment Contributions Act)⁵
If annual payments exceed $600, the company must issue Form 1099-NEC (“Nonemployee Compensation”) to the independent contractor^{1, 5}

The Impact on Taxes, Social Security, and Insurance Programs

Insurance/Tax Program	Employer	Employee	Independent Contractor	Notes
Federal Income Tax (FIT)	Must withhold	Bears the tax burden	Pays directly through tax filing	FIT is paid through W-2 withholding or self-reporting
State Income Tax (SIT)	May be required to withhold, depending on the state	Bears the tax burden	Pays directly	Taxability and rates vary by state
Social Security and Medicare (FICA)	Pays employer share	Employee share withheld from wages	No payment obligation	Social Security 6.2% and Medicare 1.45% each for employer and employee
Self-Employment Tax (SECA)	None	None	Pays full amount	Independent contractor pays the FICA equivalent (15.3%)
Federal Unemployment Tax (FUTA)	Pays full amount	No obligation	No payment obligation	Funds unemployment insurance for employees. Independent contractors are generally not covered
State Unemployment Tax (SUTA)	Employer contribution required	Generally no obligation	No payment obligation	Contribution to state unemployment insurance programs
State Disability Insurance (SDI)	Contribution may be required, depending on the state	May be withheld from wages, depending on the state	Generally not covered, though voluntary coverage may be available	Already in place in states such as California
Paid Family Leave (PFL)	Contribution may be required, depending on the state	May be withheld from wages, depending on the state	Generally not covered	Available in states such as California and New Jersey
Workers’ Compensation (WC)	Generally must provide coverage	Covered	Generally not covered	Independent contractors are usually excluded, though voluntary coverage may be possible depending on the stat

Legal Obligations and the Application of Employment Laws

Employees

Covered by the FLSA⁷
Subject to a wide range of laws, including those governing minimum wage, overtime, family and medical leave, and anti-discrimination protections
May be eligible for employee benefits such as 401(k) plans and health insurance

Independent Contractors

Generally, not covered by the FLSA
Usually not protected by laws on minimum wage, overtime, or employment discrimination, although some exceptions may apply
Not eligible for employee benefits

Key Differences in Contracts, Payment, and Day to Day Administration

Item	Employee	Independent Contractor
Contract Type	Employment agreement	Independent contractor agreement
Compensation Structure	Hourly wage, salary, annual salary, etc.	Project based or performance based
Payment Method	Paid on a regular payroll cycle	Paid based on invoices
Tax Treatment	Subject to withholding	Self reported and self paid under SECA
Year End Reporting	Form W-2	Form 1099-NEC
Time Tracking	Required	Generally flexible
Work Location / Equipment	Typically designated or provided by the company	Generally self managed and self funded

Standards for Classification Decisions: The IRS Common Law Test

What is the Common Law Test?

The IRS uses the Common Law Test to classify workers based on the actual substance of the relationship rather than labels alone.⁸ The test consists of three main evaluation categories and 20 supporting factors.

Behavioral Control
Financial Control
Type of Relationship

What each category evaluates

Behavioral Control

Whether the company directs how, when, where, and by what methods the work is performed
Whether training or manuals are provided, which generally suggests employee status

Financial Control

Whether the worker owns the tools, equipment, or other resources used for the job
Whether the worker bears their own business expenses
Whether the worker has an opportunity for profit or loss, which generally suggests independent contractor status

Type of Relationship

How the relationship is described in the contract
Whether benefits are provided
Whether the relationship is ongoing or exclusive

The IRS 20 Factor Test for Employment Status (IRS Rev. Rul. 87-41)

No.	判定要素	内容説明
1	Instructions	If the person for whom the services are performed has the right to require compliance with instructions, this indicates employee status.
2	Training	Worker training (e.g., by requiring attendance at training sessions) indicates that the person for whom services are performed wants the services performed in a particular manner (which indicates employee status)
3	Integration	Integration of the worker's services into the business operations of the person for whom services are performed is an indication of employee status.
4	Services Rendered Personally	If the services are required to be performed personally, this is an indication that the person for whom services are performed is interested in the methods used to accomplish the work (which indicates employee status).
5	Hiring, Supervising, and Paying Assistants	If the person for whom services are performed hires, supervises or pays assistants, this generally indicates employee status. However, if the worker hires and supervises others under a contract pursuant to which the worker agrees to provide material and labor and is only responsible for the result, this indicates independent contractor status.
6	Continuing Relationship	A continuing relationship between the worker and the person for whom the services are performed indicates employee status.
7	Set Hours of Work	The establishment of set hours for the worker indicates employee status.
8	Full Time Required	If the worker must devote substantially full time to the business of the person for whom services are performed, this indicates employee status. An independent contractor is free to work when and for whom he or she chooses.
9	Work Performed on Employer’s Premises	If the work is performed on the premises of the person for whom the services are performed, this indicates employee status, especially if the work could be done elsewhere.
10	Order or Sequence Test	If a worker must perform services in the order or sequence set by the person for whom services are performed, that shows the worker is not free to follow his or her own pattern of work, and indicates employee status.
11	Oral or Written Reports	A requirement that the worker submit regular reports indicates employee status.
12	Payment by Hour, Week, or Month	Payment by the hour, week, or month generally points to employment status; payment by the job or a commission indicates independent contractor.
13	Payment of Business and/or Traveling Expenses	If the person for whom the services are performed pays expenses, this indicates employee status. An employer, to control expenses, generally retains the right to direct the worker.
14	Furnishing Tools and Materials	The provision of significant tools and materials to the worker indicates employee status.
15	Significant Investment	Investment in facilities used by the worker indicates independent contractor status.
16	Realization of Profit or Loss	A worker who can realize a profit or suffer a loss as a result of the services (in addition to profit or loss ordinarily realized by employees) is generally an independent contractor.
17	Working for More Than One Firm at a Time	If a worker performs more than de minimis services for multiple firms at the same time, that generally indicates independent contractor.
18	Making Service Available to the General Public	If a worker makes his or her services available to the public on a regular and consistent basis, that indicates independent contractor status.
19	Right to Discharge	The right to discharge a worker is a factor indicating that the worker is an employee.
20	Right to Terminate	If a worker has the right to terminate the relationship with the person for whom services are performed at any time he or she wishes without incurring liability, that indicates employee status.

Important Points to Keep in Mind

Today, the three broad categories discussed above, behavioral control, financial control, and the type of the relationship, are the framework most commonly used. The 20 factor test now serves more as a supplementary tool. However, because it is still useful as a more detaiiled checklist, it is included here.
A worker does not need to meet all 20 factors. Classification is based on the overall facts and circumstances.
The actual working relationship takes priority over labels or contract language.
Depending on the state or the law involved, other tests may apply, such as the Economic Reality Test or the ABC test used in states such as New Jersey. Even so, the core areas of analysis are broadly similar.

Safe Harbor Under Section 530 and Protection Based on Past Classification Practicves

What is the Safe Harbor rule?

Even if the IRS determines during an audit that a worker was misclassified, Section 530 Safe Harbor may protect the company from additional employment tax liability if the company can show that it had a reasonable basis for the classification.⁹

Requirements for eligibility

Reasonable basis for the classification, such as reliance on court decisions, IRS or other government guidance, or advice from an attorney or tax professional
Consistent treatment overtime, meaning workers performing the same type of work have been classified the same way from past to present
Consistent tax reporting, such as issuing Form 1099-NEC to independent contractors and Form W-2 to employees as appropriate

Practical Points

It is important to retain documentation that supports the company’s reasonable basis for the classification, including contracts and their terms, tax reporting records such as Forms 1099-NEC and W-2, and records showing how the work was actually performed.
If a company asserts Safe Harbor protection during an IRS audit, the burden is generally on the IRS to show that the requirements for relief have not been met.

Examples and Cautions

Safe Harbor does not mean that the classification was affirmatively determined to be correct.
It does not serve as a blanket justification for future classifications.
Continued protection generally depends on maintaining the same classification consistently.

Form SS-8 and Form 8919: Obtaining an Official IRS Determination and Reporting Options for Workers

Form SS-8: Requesting an Official IRS Determination

Form SS-8 (“Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding”) is the form used when either a company or a worker wants to obtain an official determination from the IRS regarding a worker’s classification.^{10, 11}

Who may file it?

The employer
The worker, whether current or former

Main contents

A detailed set of questions, based on the Common Law Test, totaling roughly 50 items.
Topics include how the work is performed, the reporting relationship, ownership of tools and equipment, risk of profit or loss, and the terms of the contract.

Processing

The review process generally takes at least six months.
The IRS determination is considered administrative guidance rather than a binding legal ruling, but it can still serve as important reference material in an audit.

Important caution

While the IRS review is pending, it is generally advisable to treat the worker provisionally as an employee in practice.

Form 8919: When a Worker Claims Employee Status and Pays Their Share of Tax

Form 8919 (“Uncollected Social Security and Medicare Tax on Wages”) is used by a worker who was paid as an independent contractor but believes they were, in substance, an employee. It allows the worker to report and pay only their share of FICA taxes through their individual tax return.¹²

When is it used?

When the worker believes the employer classified them incorrectly, but the issue has not been corrected directly.
In some cases, it is filed together with Form SS-8

How the tax is handled

If the worker received a Form 1099-NEC instead of a Form W-2, they may use Form 8819 to report only the employee share of FICA taxes.
The worker does not pay the employer share of FICA taxes, although the company may later be required to do so.

Practical impact

Filing Form 8919 may trigger an IRS review or investigation of the company.
Based on the information reported, the IRS may revisit the classification and require corrective action.

State by State Differences in Worker Classification Standards: New York, New Jersey, Texas, and California

In addition to federal standards such as worker classification is also governed by state specific rules. This section compares four states where many Japanese companies operate: New York, New Jersey, Texas, and California.

New York

Supervising agency: NYSDOL (New York State Department of Labor)
New York generally applies a framework similar to the Common Law Test¹³
In the construction industry, the Construction Industry Fair Play Act creates a stricter standard, under which workers are generally presumed to be employees unless specific requirements are met, such as freedom from direction and control and engagement in an independently established business.¹⁴

New Jersey

Supervising agency: NJDOL (New Jersey Department of Labor)
New Jersey applies the strict ABC test.^{15, 16}

Requirements of the ABC test

A worker will not be classified as an independent contractor unless all of the following are satisfied:

A. The individual has been and will continue to be free from control or direction over the performance of work performed, both under contract of service and in fact; and

B. The work is either outside the usual course of the business for which such service is performed, or the work is performed outside of all the places of business of the enterprise for which such service is performed; and

C. The individual is customarily engaged in an independently established trade, occupation, profession or business.

Uber Technologies was required in New Jersey to pay $100 million in past due contributions, penalties, and interest related to the misclassification of drivers as independent contractors, after state authorities concluded that the company had improperly denied workers access to protections such as unemployment, disability, and family leave related programs.^{17, 18}

Texas

Supervising Agency: TWC (Texas Workforce Commission)
Texas evaluates employment status primarily based on factors related to the services performed, wages, and direction and control under the Texas Unemployment Compensation Act Section 201.401
To assess these factors in practice, Texas also refers to the 20-Factor Test (Refer to the The IRS 20 Factor Test for Employment Status). ¹⁹
Texas law separately defines certain gig economy workers, including some app based and freelance workers, as Marketplace Contractor (40 T.A.C. §815.134(b))²⁰

California

Supervising agency: DIR (California Department of Industrial Relations), among others
California generally applies the ABC test across industrries²¹
This framework was established through the Dynamex decision in 2018 and later codified through AB 5 (Assembly Bill 5), which took effect in 2019^{21, 22, 23}
California also expressly lists statutory exemptions for certain occupations²³
For some exempt professions, such as certain lawyers, physicians, and construction related businesses, the Borello test, a broader common law balancing test, may apply instead
Because of California’s regulatory environment, misclassification can create especially significant exposure, including penalties and class action risk

State by State Comparison Table

State	Standard Used	Key Feature
New York	Common Law + construction industry rule	Construction workers are generally presumed to be employees
New Jersey	ABC test (strict)	High bar for independent contractor status
Texas	20 factor test + Marketplace Contractor rule	More flexible and generally more business friendly
California	ABC test (AB 5)	Applies broadly across industries, with limited exceptions. Penalties can be severe.

Practical Contract Drafting Considerations: How to Structure Agreements and Wording to Reduce Misclassification Risk

To reduce worker classification risk, both the service agreement and the employment agreement are critically important. That said, it is risky to assume that simply labeling someone an “independent contractor” in a contract is enough. The IRS, the DOL, and state labor and enforcement agencies look at the actual working relationship, not just the wording of the agreement. In other words, contract language is only supporting evidence, not the deciding factor.

Even so, when a contract is properly drafted, it can serve as helpful evidence supporting the reasonableness of the classification.

Key Clauses to Include in the Contract

Clause	Purpose	Sample Language (Excerpt)
Statement of independent status	Clarifies that no employment relationship is intended	“This agreement shall not create an employer-employee relationship...”
Clear scope of services	Defines the services and deliverables	“Contractor shall perform the following services...”
Control over time and place of work	Shows that the worker retains discretion over how the work is performed	“Contractor shall determine the time, place, and manner...”
Payment structure	Uses deliverable based or project based compensation	“Contractor shall be paid $X,XXX.XX per deliverable...”
Responsibility for expenses	States that the worker bears their own expenses, tools, and travel costs	“Contractor is solely responsible for all expenses...”
Right to subcontract	Allows the contractor to hire assistants or subcontractors	“Contractor may employ assistants or subcontractors...”
Limited contract term	Preferably ties the agreement to a specific project or deliverable	“This agreement shall terminate upon delivery of…”

Note: When preparing an actual contract, you should have it drafted or reviewed by internal or external legal counsel who is experienced in the relevant business activity and employment related matters.

Checklist for Maintaining the Classification

Is the worker free from mandatory company set hours or work location requirements?
Is the worker not required to follow an employee style operations manual?
Is the worker paid on a deliverable or project basis rather than a fixed salary?
Is the worker not receiving employee style benefits?
Has the company avoided giving the worker branded business cards or a company email address?

Common Mistakes and Related Risks

Mistake	Risk
Using the term “contract employee”	May suggest an employment relationship
Paying a fixed monthly amount	May be viewed as salary like compensation, suggesting employee status
Requiring full time work	May indicate control over work hours and support employee classification

Response Flow and Corrective Steps When Misclassification Is Discovered

If a company discovers that a worker who should have been treated as an employee was instead classified as an independent contractor, both tax and legal action may be required.

How Misclassification Is Typically Discovered

IRS audit, such as for withholding or unpaid FICA taxes
DOL investigation, such as for minimum wage or overtime issues
State unemployment insurance or worker’s compensation audit
Worker field report, including through Form 8819
Class action litigation

Initial Response Steps

Preserve key records, including contracts, time records, payment records, and management instructions
Reevaluate the classification under the Common Law Test, ABC test, or other applicable standard
Consult qualified professionals immediately, such as employment counsel and tax advisor
Prepare for correction and amended filings, including reissued Form W-2 and amended Form 941 filings if needed

Using the VCSP

A company may be able to use the VCSP (Voluntary Classification Settlement Program) ²⁴ to reclassify workers as employees while reducing part of its past FICA tax exposure.

Key Requirements

The company is not currently under audit
The company agrees to treat the workers as employees going forward and issue Form W-2
The company pays a reduced amount, generally equal to 10% of the employment tax liability that would have been due for the most recent tax year

Preventive Measures

Item	Description
Internal classification standards	Prepare internal guidance summarizing IRS and state classification
Standardized contract templates	Review templates regularly through coordination between legal and HR
Training	Provide practical training for managers, HR, and accounting
Ongoing monitoring	Conduct semiannual or annual reviews of actual contractor

Consolidated Checklist and a Model Plan for Internal Compliance Structure

Consolidated Checklist

Classification Review

Have you reviewed the IRS Common Law Test?
Have you checked for any state specific tests, such as the ABC test?
Is the classification approach being applied consistently?

Contracts and Tax Compliance

Does the agreement clearly state the worker’s independence and project or results based arrangement?
Have you obtained Form W-9 (Request for Taxpayer Identification Number and Certification) or Form W-4 (Employee’s Withholding Certificate), as applicable?
Are Form 1099-NEC and Form W-2 being issued correctly?

Operations and Audit Readiness

Are day to day work and management records being retained?
Are the supporting reasons for past classifications being documented and saved?
Have you identified any workers who may potentially file Form SS-8 or Form 8919?

Model Internal Compliance Structure

Step 1: Establish internal classification guidelines based on the Common Law Test and applicable state standards

Step 2: Standardize templates for independent contractor agreements and employment agreements

Step 3: Conduct training at least once a year for managers and relevant personnel

Step 4: Perform an annual review of actual working relationships and assess classification risk

Step 5: Prepare a correction manual and an audit response workflow

References

Author Shinsuke Kiyono

Founder & CEO, Cornerstone Strategy LLC

Shinsuke Kiyono has10+ years of experience in organizational and talent consulting, having worked at Accenture, Deloitte Tohmatsu Consulting, and an AI startup. In October 2024, he founded Cornerstone Strategy LLC, where he supports Japanese companies in the United States in building HR functions and advancing organizational and talent development.

Disclaimer

This article has been prepared by Cornerstone Strategy LLC for informational purposes only. It is based on generally available information, including publicly available guidelines, regulations, and case law related to U.S. human resources, employment, tax practices, organizational and talent development, leadership development, career development, and coaching. It is provided from the perspective of an HR consultant and coach.

Cornerstone Strategy LLC is not a law firm, accounting firm, licensed tax advisory firm, medical provider, psychotherapy provider, counseling provider, or any other licensed professional practice providing legal, tax, medical, psychological, or therapeutic services.

The content of this article does not constitute legal, accounting, tax, medical, psychological, therapeutic, investment, or other professional advice, and should not be relied upon as such. It does not guarantee legal validity, tax treatment, organizational outcomes, HR outcomes, behavioral change, career outcomes, coaching outcomes, or applicability to any specific situation.

Before making decisions related to employment, tax, contracts, compensation, termination, disciplinary action, HR policies, required forms, or any matter involving physical or mental health, you should consult with qualified professionals such as licensed attorneys, certified public accountants (CPAs), tax advisors, medical professionals, psychologists, or other appropriately licensed professionals who are knowledgeable about applicable federal and state laws and professional standards.

Cornerstone Strategy LLC assumes no responsibility or liability for any loss or damages arising from the use of, reliance on, or actions taken based on this article.