The gig economy has exploded over the past decade. From Fiverr to Uber, from seasonal warehouse workers to freelance accountants, the line between employee and independent contractor has become increasingly blurred. California alone spent years in legal battles over worker classification, with court cases dragging on and state laws changing back and forth.
However, a single worker can legally be an “employee” under one federal law and an “independent contractor” under another for the same work, at the same time. And thanks to the One Big, Beautiful Bill Act, this distinction directly impacts your tax practice.
In Episode 24 of Tax in Action, Jeremy Wells, EA, CPA, tackles this complexity head-on in the first part of a two-part series on worker classification and misclassification. He breaks down exactly how the IRS distinguishes between employees and independent contractors and why tax professionals cannot ignore definitions that come from outside the Internal Revenue Code.
Payroll Taxes Are at the Heart of This Discussion
As Jeremy emphasizes early in the episode, “the tax consequences can be significant for both the employer and the worker.” The gig economy creates opportunities for flexible work, but also leaves workers without employment benefits, fair labor protections, and payroll tax matching.
Payroll taxes are “really the most important aspect of this discussion from a tax perspective,” Jeremy explains. It comes down to who’s responsible for the payroll tax or self-employment tax that results from the money earned.
The stakes are high. Misclassifying a worker can lead to both the employer and worker facing tax liabilities that compound quickly. Get it right, and everyone knows where they stand with FICA, FUTA, and federal income tax withholding.
One Word, Multiple Federal Definitions
For most of our careers, we’ve operated within the comfortable boundaries of Title 26, the Internal Revenue Code. If someone mentioned the Fair Labor Standards Act (FLSA), we knew that was the labor lawyers’ territory. Not anymore.
Jeremy explains that “employee” means different things in different contexts across federal law. There’s a well-established principle that a term should have the same meaning within a single title of the U.S. Code, but it can mean something entirely different when you cross from one title to another.
The Department of Labor uses what it calls the “economic reality test” to determine employee status under the FLSA. This test examines six factors:
- Opportunity for profit or loss based on managerial skill
- Investments by both parties
- Permanence of the relationship
- Nature and degree of control
- Whether the work is integral to the employer’s business
- The worker’s skill and initiative
The key question for the DOL is economic dependence. As Jeremy notes from the DOL’s Fact Sheet 13, “If the economic realities show that the worker is economically dependent on the employer for work, then the worker is an employee.”
The critical distinction is that the DOL explicitly states, “employment under the FLSA is not determined by technical concepts or common law standards of control. It is broader than the common law standard often applied to determine employment status under other federal laws.”
The 2025 Change
Why does this matter for tax professionals? The One Big, Beautiful Bill Act created a new deduction for overtime pay, but it specifically references FLSA Section 7, which deals with employees entitled to overtime compensation.
“An employee who is covered under FLSA Section 7 may qualify for a deduction for part of the overtime payment that the worker earned,” Jeremy explains, highlighting the significance.
This creates an unprecedented situation because “a worker can be considered an employee under FLSA and therefore eligible for potentially deductible overtime, yet not considered an employee for federal employment tax purposes.”
The IRS recognized this gap. In Notice 2025-69, the agency provides guidance on “how employers should report overtime paid to workers who are covered under FLSA Section 7 but are not employees for payroll tax purposes and so won’t receive a W-2.”
The IRS Control Standard: Three Categories That Drive Every Decision
So how does the IRS actually decide who’s an employee? It starts with IRC Section 3121(d), which provides four statutory definitions: common law employees, and corporate officers, certain statutory employees, certain statutory nonemployees.
For most situations, we’re dealing with the common law employee definition. That definition hinges on the common law “right to control” standard, which comes from Supreme Court precedent.
The standard boils down to one question: Does the employer retain the right to direct and control the means and details of the work?
“It’s less about whether the employer actually does control the worker, and more about whether the employer retains the right to control the worker,” Jeremy says, emphasizing a crucial distinction.
An independent contractor, by contrast, is “typically subject to control only as to the desired result, not the means or the methods of doing the work.”
The Evolution from 20 Factors to Three Categories
Courts have spent roughly half a century developing this definition. Key cases include Weber v. Commissioner (1994), Professional and Executive Leasing, Inc. v. Commissioner (Ninth Circuit, 1988), and Simpson v. Commissioner (Tax Court, 1975).
In 1987, the IRS and Social Security Administration compiled 20 factors from court precedents and published them in Revenue Ruling 87-41. Then in 1996, the IRS reorganized these into three categories of evidence in an examiner training manual. Jeremy stresses these are “categories of evidence. They are not themselves legal tests.”
Behavioral Control: The Details and Means of Performance
This category examines whether the employer has “the right to direct or control the details and means by which the worker performs the required services.”
Key indicators include:
- Instructions: Jeremy uses a simple example: “If I hire a worker and tell that worker, ‘I need you to produce a widget for me,’ and I don’t tell them anything more than that, then I have given that worker essentially no instruction.” That leans toward independent contractor. But if you specify the tools, timeline, location, and step-by-step process, that leans toward employee.
- Evaluation: Monitoring how work is performed (not just the final result) indicates greater control.
- Training: Required, periodic, or ongoing training on methods and procedures suggests employment.
- Uniforms and branding: These can indicate employment, but Jeremy notes modern realities. “Customer security concerns have led some of these companies to insist that their workers dress up in their uniforms, and have their logos displayed even though they’re classified as independent contractors.”
Jeremy adds a nuance particularly relevant for professionals: “Instructions imposed by the business merely to ensure compliance with customer orders or governmental or governing body regulations may indicate weaker control than more stringent guidelines imposed directly by the business.”
Financial Control: The Economic Aspects
This category looks at “the right to direct or control the economic and business aspects of the worker’s activities.”
Important factors include:
- Significant investment: Who provides equipment and pays for large expenditures? Jeremy notes everything is relative. “I run an accounting firm. The biggest equipment expense we have is computers. That’s nothing compared to buying large equipment for a factory.”
- Business expenses: “Choosing to incur unreimbursed expenses typically indicates that the worker has the right to direct and control the financial aspects of the business operations.”
- Market availability: Can the worker seek other business opportunities? Jeremy emphasizes a critical distinction from the DOL test, citing Nationwide Mutual Insurance Co. v. Darden (Supreme Court, 1992): “The question here is whether the worker has the right to direct and control business-related means and details of the worker’s performance, not whether the worker is economically dependent.”
- Method of payment: Guaranteed salary or hourly wages typically indicate employment, though Jeremy notes “plenty of independent contractors, especially freelancers and firms as well, bill for time.”
Relationship of the Parties: Intent Concerning Control
This category examines how both parties perceive their relationship.
- Written agreements: These help establish intent, but Jeremy warns, “Just because something’s in writing doesn’t necessarily make it so. We still have to look at the substance of the relationship.”
- Incorporation: If a worker operates through a legitimate entity that “follows corporate formalities and has at least one non-tax business purpose,” that generally supports independent contractor status.
- Employee benefits: Certain benefits, such as tax-qualified retirement plans, 403(b) annuities, and cafeteria plans, can only be provided to employees. Benefits paid to contractors can often uncover a worker misclassification case. Jeremy is clear: “If we see any of these kinds of benefits, then by definition, we have an employee.”
The S Corporation Officer Trap
Jeremy saves one of his strongest warnings for corporate officers. “Corporate officers are generally considered employees, especially if they are providing services to the corporation.”
For S corporations, this is critical. “An officer of an S corporation that provides services to that corporation is an employee, meaning that individual needs to be paid wages.”
The only exception requires meeting both conditions: the officer provides minor or no services AND is not entitled to receive any pay, directly or indirectly.
Jeremy calls out a common but problematic practice. “One way some tax professionals try to use two wrongs to make a right is issuing a 1099-NEC from the S corporation to that individual. Two wrongs don’t make a right.”
“Even though they both go into Social Security and Medicare, paying self-employment tax is different from paying FICA.” The tax liabilities remain; you’ve just created documentation of the misclassification.
Interestingly, Jeremy notes that one person can legitimately receive both a W-2 and 1099 from the same corporation. “You can have an individual working as an officer for a corporation and as a director for a corporation. That individual’s wages earned as an officer would be reported as wages on a form W-2, and then that individual’s pay as a director would be paid as compensation to a non-employee.”
Most Workers Live on a Spectrum
Jeremy brings us back to practical reality. “In the real world it’s a spectrum. On one end of that spectrum is a pure independent contractor where the employer just says, this is what we want you to do. Now go do it. On the other end, we have an employee where the employer tells the employee exactly how to do every single step.”
Most workers fall somewhere in between. As tax professionals, Jeremy explains, “we might have to make a determination of which end of that spectrum does this worker lean toward more?”
What Comes Next
This episode is part one of a two-part series. In part two, Jeremy will cover what happens when we have a misclassification and what workers and employers can do about that misclassification.
For now, the practical takeaways are:
- Learn the DOL’s economic reality test. The overtime deduction depends on it.
- Review IRS Notice 2025-69 for guidance on FLSA-covered workers who aren’t employees for tax purposes.
- Use the three categories of evidence as your analytical framework, remembering the underlying legal test is the control standard.
- Audit your S corporation clients. Officers providing services must be on payroll.
- Document substance over labels in all worker relationships.
Listen to the full episode of Tax in Action to hear Jeremy walk through the complete analysis, including all the court cases and regulatory citations that inform these critical classification decisions.