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Business owners are eager to classify a worker as an IC because there is much less paperwork and expense. However, both the IRS and your state taxing authority or employment board may impose significant penalties if you misclassify an employee as an IC, and there are plenty of ways to get caught. For example, if someone you hired as an IC applies for unemployment, your state’s unemployment insurance agency might decide that the worker was really an employee — and is entitled to unemployment compensation. Something similar might happen with your state’s workers’ compensation board or tax agency.
However, the agency you need to be most concerned about is the IRS — both because it imposes hefty penalties for misclassification and because it will have more contact with your business (and more opportunities to look closely at how you classify your workers). The IRS test considers workers employees if the company they work for has the right to direct and control the way they work — including the details of when, where, and how the job is accomplished. In contrast, the IRS considers workers independent contractors if the company they work for does not manage how they work, except to accept or reject their final work product.