Employee or Contractor? Why Misclassification Is a Costly Risk

Knowing whether to classify a worker as an employee or an independent contractor is a critical business decision. Get it right, and you can save money, reduce administrative burdens, and maintain flexibility. Get it wrong, and you could face significant costs from government agencies like the Department of Labor (DOL) or the IRS.

Using independent contractors can be a cost-effective strategy. You avoid long-term commitments, paying the employer's share of employment taxes, and providing benefits. However, with shifting regulations and multiple government bodies each using their own tests, correctly classifying workers has become a complex challenge. Misclassification can lead to steep penalties, back pay, and unpaid taxes, making it essential to understand the rules.

This post will explore the key factors that determine a worker's status and explain why making the right choice is so important for your business's financial health.

Shifting rules and definitions

Worker classification rules have seen some changes recently. When President Trump took office in January 2025, his DOL put a hold on the previous administration's multifactor approach, which weighed several "economic realities" to determine worker status.

While the Trump DOL is still developing its new standard, many expect it to resemble the one from his first term. That system placed a heavy emphasis on two primary factors:

1. The nature and degree of the worker’s control over their work.
2. The worker’s opportunity for profit or loss.

This shift highlights how political changes can directly impact how businesses are expected to classify their workforce. It’s a reminder that staying compliant requires staying informed.

How worker status is determined

The Fair Labor Standards Act (FLSA) doesn't actually provide a definition for "independent contractor." Because of this, the DOL and the courts have developed a "totality of circumstances" approach. This means they look at the entire working relationship rather than relying on a single rule.

Some of the key factors considered include:

• Integral Services: How essential are the worker's services to your core business or mission?
• Permanency: Is the relationship ongoing and long-term, or is it for a specific, finite project?
• Control: How much control does your organization have over the worker, including their hours, methods, and location?
• Investment: Does the worker invest in their own tools, equipment, and facilities?
• Profit and Loss: Does the worker have a real opportunity to make a profit or risk a loss based on their own management and decisions?
• Business Operation: Does the worker operate as an independent business entity?

The DOL might also look at other details, like where the work is performed and whether a formal independent contractor agreement is in place. To make things more complex, some states have even stricter tests. Also, a worker who qualifies as a contractor under the FLSA might still be considered an employee by another agency, like the IRS, which uses its own distinct test.

The risks of misclassification

The distinction between an employee and a contractor carries significant financial and legal weight. If a worker is classified as an employee under the FLSA, you are generally required to pay minimum wage, overtime, and meet other labor requirements. For tax purposes, this means paying the employer's portion of Social Security and Medicare taxes and withholding various taxes from the employee's pay.

Failing to classify a worker correctly can be expensive. Your organization could be held liable for:

• Unpaid back wages and overtime.
• Unpaid employment taxes.
• Workers' compensation premiums.
• Unpaid leave and other benefits.
• Additional fines and penalties.

These costs can add up quickly, turning what seemed like a cost-saving measure into a major financial liability.

Navigating the challenge

The rules for classifying workers are constantly evolving, making it a persistent challenge for businesses and nonprofits. With different tests applied by various federal and state agencies, ensuring compliance requires careful consideration of each working relationship.

If you're unsure about how to classify a worker or want to review your current practices, it's wise to seek expert guidance. Making the right decision from the start protects your business and ensures you stay on the right side of the law.