Part 11: Employees vs. Independent Contractors — How Home-Business Owners Should Classify Workers

Employees vs. Independent Contractors — How Home-Business Owners Should Classify Workers (2025)

Hiring help can grow your home business — but misclassifying workers is one of the most costly IRS mistakes.
The IRS requires home-business owners to correctly determine whether a worker is an employee or an independent contractor.
This guide explains the IRS 3-factor test, tax obligations, deduction rules, and special family-employee rules for 2025.

1️⃣ Employee vs. Contractor — What’s the Difference?

Per Chapter 11, the classification hinges on the level of control you have over the worker.
Employees work under your control, while independent contractors operate independently.

• 👷 Employee: You control how, when, and where the work is done.
• 🧰 Independent Contractor: Hired for a specific project or service, controlling their own methods.

Misclassification can trigger taxes, penalties, and interest — even for small home businesses.

2️⃣ The IRS 3-Factor Classification Test

The IRS uses a simplified 3-factor test (behavioral, financial, relationship) to determine status.
These factors replaced the old 20-factor test and mirror guidance in Chapter 11.

✔️ Behavioral Control

• Do you provide instructions?
• Do you require specific work hours?
• Do you train the worker?

✔️ Financial Control

• Who provides tools & equipment?
• How is the worker paid — hourly vs. per project?
• Does the worker have unreimbursed expenses?

✔️ Nature of the Relationship

• Is there a written contract?
• Does the worker receive employee benefits?
• Is the work ongoing or project-based?

3️⃣ Tax Obligations for Each Worker Type

👷 Employees

Employers must:

• Withhold federal income tax
• Pay employer’s share of Social Security & Medicare taxes
• Pay federal & state unemployment taxes (FUTA/SUTA)
• Provide W-2 at year-end

🧰 Independent Contractors

For contractors, businesses must:

• Issue Form 1099-NEC if paid $600+
• No tax withholding required
• No benefits or unemployment taxes required

4️⃣ Special Rules for Hiring Family Members

Chapter 11 explains unique rules when hiring your spouse or children.
These rules provide tax advantages but must follow IRS guidelines.

• ✔️ Hiring your spouse may allow joint venture classification.
• ✔️ Hiring your minor child (under 18) may avoid FICA taxes in a sole proprietorship.
• ✔️ Payments must be reasonable and for actual work performed.

5️⃣ Deductible Costs When Hiring Help

You may deduct all ordinary and necessary costs of hiring workers, including:

• ✔️ Wages & salaries
• ✔️ Employer payroll taxes
• ✔️ Contractor payments
• ✔️ Employee benefits
• ✔️ Training & recruitment

6️⃣ Real Examples

7️⃣ Documentation Requirements

Worker classification is one of the most common audit triggers — clean records protect your business.

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