Today, there are 57 million workers participating in the booming gig economy. That’s a whopping 36% of the entire US workforce—and it’s making the line between independent contractors and employees blurrier than ever before.

If you’re wondering why the distinction even matters, consider Uber’s recent worker classification kerfuffle. Uber has long based its business model on classifying its entire workforce as independent contractors.

But back in 2015, an Uber driver approached the California Labor Commissioner to decide if she was an independent contractor (as Uber claimed) or if she was an employee (as she claimed). The Labor Commissioner ultimately ruled that the driver was an employee, and as a result, was entitled to be reimbursed by Uber for up to $4,152 in expenses.

There's more at stake than just one Uber driver getting reimbursed for job-related expenses. Employers are responsible for collecting taxes through payroll withholding and are responsible for paying half of Social Security and Medicare taxes, unemployment insurance taxes, and maintaining workers' compensation insurance. So with over 900,000 active drivers in the United States, Uber could have faced millions of dollars in damages if its drivers were classified as employees.

That’s why, in 2019, the National Labor Relations Board decided once and for all that Uber drivers are not employees, but independent contractors instead.

Uber’s story is just one of many examples, and it shows just how vital correctly classifying your workers really is. But for a lot of companies, there’s only one major problem: They don’t know how to correctly classify their workers—or why it even matters.

Here’s how to distinguish employees versus independent contractors—and what’s at stake if you don’t.

When You Hire An Employee

A worker is considered an employee if you control the work they’re tasked with, how it’s done, and when it’s done. The employing company has the right to define, control, and manage these details, and employees who refuse to follow those guidelines put themselves at risk of losing their job.

An employee also has their federal and state taxes, Social Security, and Medicare withheld from their paychecks. Employees are also offered benefits, including paid sick leave, vacation, health insurance, and retirement plans.

As the employer, this means the IRS requires that you file special paperwork for employees. For each employee hired, you’ll need to collect a Social Security number to enter on an annual Form W-2 wage and tax statement, as well as a signed Form W-4 that provides the information needed to calculate the amount of federal income tax to be withheld from each paycheck.

When You Hire An Independent Contractor

In contrast, an independent contractor decides how and when the work will be done. And more often than not, the contract is project-based.

Independent contractors typically set their own hours and are paid as freelancers, either with a flat fee or hourly rate. The duration of their work, their independent project deadlines, and the details of their pay are generally determined by a contract.

As the employer, you’ll need to file a Form 1099, which includes the combined totals for an independent contractor paid $600 or more during the previous tax year. It’s also important to note that you won’t withhold any taxes from a contractor's wages. Instead, independent contractors are responsible for paying their own taxes to the IRS through a process of estimated quarterly taxes.

Independent contractors also aren’t entitled to benefits, making them solely responsible for securing their own medical, dental, and long-term care insurance.

Here’s How The IRS Determines Worker Status

Even though the general classifications seem pretty straightforward, there’s still some grey area. The truth is, there’s no one-size-fits-all way to know if a worker is an independent contractor or employee. That’s because the IRS looks at each situation on a case-by-case basis.

Fortunately, the IRS uses a few guidelines to make the distinction a little more clear, no matter your scenario. You can use those guidelines, too, to see how your workers might fit into your business.

Behavioral Control

If you train and direct the person’s workload, including hours of work, what tools or equipment they should use, specific tasks to be performed, and how the work is to be done, the worker is likely an employee.

If the worker can set their own hours and works with little or no direction, he or she is probably an independent contractor.

Financial Control

Do you control certain aspects of the worker's finances? This includes things like how and when the worker is paid, whether expenses are reimbursed, and whether or not paid vacation and paid sick leave are offered. If so, your worker is likely an employee.

Here’s another indicator: If your worker is paid on salary, they’re an employee. If the worker is paid a flat fee per project or by the hour (generally at a price the worker sets), they’re probably an independent contractor.

Type of Relationship

Are there written contracts or employee benefits, such as vacation pay, pension plans, or insurance?  If the worker is entitled to benefits, this usually indicates an employment relationship.

Another thing to consider is the type of work the person does. Is their work directly related to the company's core work? If so, they’re probably an employee. For example, if you run a new tech company and hire a copywriter to build messaging for your new landing page, you’re most likely hiring an independent contractor. But if you’re hiring a software developer to build your core product, that’s a pretty clear indicator they’re an employee.

Repercussions of Misclassifying a Worker

According to the IRS, “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. Also, factors which are relevant in one situation may not be relevant in another.”

Many businesses mistakenly believe this means they have some wiggle room in determining how to classify their workers, but this just isn’t the case. In fact, the IRS estimates that millions of workers have been misclassified, and according to state-level studies, 10-20% of employers misclassify at least one worker as an independent contractor.

Misclassifying workers can be costly, as you’ll be subject to fines and back taxes. On both the federal and state levels, fines can be as much as 100% of the employment tax due. In addition, companies can also be liable for all federal income tax not withheld, all Social Security taxes not withheld and unemployment tax insurance.

If you’re still in doubt and need help with the classification, you can file a Form SS-8 to request a determination from the IRS.