Independent contractor vs. employee: The complete guide for businesses

Did you hire an independent contractor or a traditional employee? Here's how to ensure proper classification — and avoid tax issues and other challenges

By Sarah Stasik6 min readUpdated August 10, 2025

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Independent contractor vs. employee: The complete guide for businesses

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The way we work is changing rapidly. According to the freelance broker site Upwork, almost 30% of skilled knowledge workers operate as independent professionals in 2025, and more than half of Americans are working a side hustle at least periodically.

Numerous factors drive the rise of the gig economy and freelance work. Financial pressures have pushed some to seek secondary incomes, but business leaders also value freelancer contributions. In fact, almost 80% of CEOs say top freelancers contribute more value to organizations than traditional employees with degrees, and around half of CEOs plan to work with more freelancers in upcoming years.

For businesses looking at freelance labor options, proper classification matters. Calling traditional workers freelancers — and paying them as such — can leave companies open to tax challenges and other issues. This guide helps businesses avoid costly missteps and better support workforces with proper classification.

The difference between an independent contractor and an employee

Classifying workers correctly requires considering how much control a business exerts over them and the nature of the relationship between employer and worker. Typically, a lot of control on the part of the business — or a lack of independence on the part of the worker — indicates the worker may be an employee.

The Internal Revenue Service (IRS) provides guidelines U.S. businesses should follow in classifying workers.

Best practices for classifying workers correctly

Start by considering the nature of the role — what you need and how the worker provides it. Consider questions like:

How will assignments be sent?
Does the worker have independence in taking on assignments?
Where and when is work completed?
Who's responsible for supply and equipment costs?

The IRS uses Form SS-8 to gather information when determining whether a worker is properly classified. Businesses can use this form to help them think about whether someone is an employee or an independent contractor.

It's also important to:

Draft clear contracts detailing freelancer and employee roles
Conduct regular audits of worker roles to ensure a freelancer hasn't slid into an employee function, and vice versa
Train hiring managers and leaders to understand classification guidelines

When in doubt, consult a labor attorney or HR specialist to ensure workers are properly classified.

The IRS 3-factor test: Behavioral, financial, and relationship control

IRS guidelines rely on a three-factor test that examines the level of behavioral and financial control and the nature of the relationship between the business and the worker. Properly applying the IRS's three-factor test ensures accurate worker classification, helping businesses avoid legal penalties and maintain compliance with tax laws and labor regulations.

Behavioral control

Behavioral control is how much say a company has over the daily activities of a worker. A business that dictates specific hours, provides in-depth instruction or requires certain methods of production typically hires employees.

For example, Uber $UBER drivers generally choose when and where they work. They use their own vehicles and decide which rides to accept. While they must follow general Uber policies, they have a level of autonomy that supports their classification as independent contractors.

Financial control

Financial control is how much independence a worker has over financial outcomes. Independent contractors usually invest in their own supplies and aren't reimbursed for all expenses. They have the potential to lose money or earn more based on how they manage their business, work, and time.

For example, a freelance graphic designer typically buys their own design software and invoices clients for work performed. They have the freedom to negotiate rates and increase their output to drive up revenue. In contrast, an in-house graphic designer is paid a set salary for the work performed.

Type of relationship

The nature of the relationship can impact worker classification. Written contracts, the provision of benefits, or taking on a role central to a company's operation can all change the proper classification.

For example, if a company hires a long-term social media manager who receives health benefits and attends weekly leadership meetings, that person should likely be classified as an employee. On the other hand, a social media coordinator who provides marketing content and administration services according to their own schedule and doesn't receive benefits may be a freelancer.

Why proper classification matters

Misclassifying workers is more than a paperwork error. It can lead to serious legal and financial consequences as well as confusion for workers. Incorrect classification can undermine your long-term business strategies and lead to distrust and morale issues among your workforce.

Here's what can be at stake:

IRS penalties, including back taxes, interest, and fines for misclassified workers
State-level consequences, including additional audits, fines, and benefit liabilities
Wage claims and unemployment insurance liability, as misclassified workers may file claims for unpaid benefits
Damage to brand reputation, as classification errors can erode trust with workers and the public
Misaligned expectations with workers, as blurred roles lead to communication breakdowns and dissatisfaction

Common misclassification mistakes and how to avoid them

Even careful businesses can misclassify workers by overlooking small details. Here are some pitfalls to avoid:

Having a contractor do employee-level work full-time under supervision: If a contractor reports to a manager daily and follows strict processes, they may legally be an employee.
Calling someone a contractor without a signed agreement: Verbal agreements aren’t enough. Always use written contracts outlining scope, payment terms, and classification.
Assuming that remote workers are contractors: Location doesn’t determine status. Focus on control, independence, and how the role fits your business.
Failing to update classifications as roles evolve: Freelancers who become essential team members may need reclassification.
Failing to consult legal or HR professionals: Classification rules can be complex. When in doubt, get guidance to protect your business.

When to hire a contractor vs. an employee

Choosing between a contractor and an employee requires considering more than your bottom line. You need to think about how the role fits into your business's structure, goals, and workflow.

Contractor is ideal when:

You need short-term or specialized help. Hiring a freelance developer to build a website or a consultant to audit your marketing strategy is often more efficient than onboarding a new employee.
Budget flexibility is important. Contractors are typically paid per project or hourly, which can help manage fluctuating workloads. For example, if you need extra online marketing content for the holidays, you can rely on freelancers.
The role is not core to business operations. If the work is supportive but not mission-critical — like event photography or decor — a contractor can meet your needs.

Employee is better when:

You need long-term, integrated team members. A full-time customer support lead or product manager is more effective as a permanent staff member.
You want control over how work is done. Employees can be trained to follow specific processes and represent your brand directly.

You plan to invest in training and benefits. If you're offering mentorship, upskilling opportunities, or health benefits, the investment makes more sense with a long-term employee.

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