13.1 Employee vs. Independent Contractor
Key Takeaways
- Classification based on "Right to Control" under common law (IRS three-category test: behavioral, financial, relationship).
- Misclassification = employer liable for FICA, FUTA, and income tax withholding.
- Section 530 Safe Harbor: filed 1099s, substantive consistency, reasonable basis.
- Form SS-8: request IRS determination of status (filed by worker or business).
- IRC §3509: reduced rates for non-willful misclassification (1.5% income / 20% FICA if 1099s filed; 3.0% / 40% if not).
- 2025 FICA: SS wage base $176,100 (max employee tax $10,918.20); Medicare 1.45% uncapped + 0.9% additional above $200K Single / $250K MFJ.
Why This Matters for the Exam
Worker classification is heavily tested. Misclassification is one of the most expensive tax errors a business can make.
Exam Note: For the July 1, 2026 – February 28, 2027 testing window, you are tested on classification rules as of December 31, 2025 (Tax Year 2025, post-OBBBA).
Expect at least 4-5 questions on classification.
The Core Distinction (2025)
| Factor | Employee (W-2) | Contractor (1099-NEC) |
|---|---|---|
| Control | Employer controls how | Worker controls result only |
| Income tax | Withheld by employer | Pays own estimated taxes |
| FICA | Split 7.65% each side (SS wage base $176,100; max employee SS $10,918.20) | SE tax 15.3% on net earnings (max SS portion $21,836.40) |
| FUTA | Employer pays (6.0% on first $7,000) | N/A |
| Reporting | Form W-2 | Form 1099-NEC ($600 threshold for 2025) |
| Expenses | Generally not deductible (TCJA suspends misc 2% — made permanent by OBBBA) | Schedule C |
Common Law "Right to Control"
The IRS replaced the legacy 20-factor test with a three-category framework (behavioral, financial, type of relationship). See 13.2 for the full breakdown.
| Element | Description |
|---|---|
| Key question | Does business control HOW work is done? |
| Not just result | Control over methods = employee |
| Contract label | IRS looks at actual facts, not the label |
Misclassification Consequences
| Liability | Description |
|---|---|
| Employer FICA | 6.2% SS (up to $176,100 wage base) + 1.45% Medicare |
| Employee FICA | Often shifted to employer (or reduced under §3509) |
| Federal withholding | Statutory percentages |
| FUTA | 0.6%–6.0% on first $7,000 |
| Penalties | §6651 (failure to file), §6656 (failure to deposit), §6672 TFRP for trust-fund portion |
Section 530 Safe Harbor
| Requirement | Description |
|---|---|
| 1. Reporting consistency | Filed 1099-NEC for the worker (2025 threshold: $600) |
| 2. Substantive consistency | All similar workers treated the same way |
| 3. Reasonable basis | Prior audit, judicial precedent, long-standing industry practice, or written advice |
Form SS-8
| Element | Description |
|---|---|
| Purpose | Request IRS determination of worker status |
| Who files | Either the worker or the business |
| Caution | Often results in employee classification |
IRC §3509 Relief (Non-Willful Misclassification)
| Filed 1099s? | Income Tax Rate | Employee FICA Rate |
|---|---|---|
| Yes | 1.5% | 20% of employee share |
| No | 3.0% | 40% of employee share |
The employer's own share of FICA is still owed in full.
Real-World Scenario
Scenario: A company misclassifies 10 workers as contractors in 2025 but filed 1099-NEC for each ($600 threshold met).
- Section 530: May qualify (filed 1099s, consistent treatment, reasonable basis).
- If not: IRC §3509 applies — reduced rates (1.5% income, 20% employee FICA).
- Without 1099s: 3.0% income, 40% employee FICA.
On the Exam
Expect 4-5 questions on classification, typically:
- Classification Questions: "Is this worker employee or contractor?"
- Safe Harbor Questions: "What is required for Section 530 relief?"
- Consequence Questions: "What taxes does the employer owe?"
The key is to remember: Right to control = employee. Section 530 = 1099s + consistency + reasonable basis. §3509 = reduced rates if non-willful.
Plumber: own tools, sets hours, multiple clients, no supervision. Classification?
What must a business do for Section 530 relief?
Misclassified worker—what federal tax does employer owe?