Employee classification is how a company legally categorizes team members, such as the difference between exempt and non-exempt employees and independent contractors. Studies show that 10% to 30% of workers may be misclassified, affecting millions of people. Getting classification wrong creates avoidable roadblocks: inaccurate payroll calculations can hurt employee morale and create IRS compliance issues. Proper classification supports accurate payroll, taxes, and benefits, while misclassification exposes your business to legal and financial risks.
What you’ll learn
What you’ll learn
Key takeaways
- Accurate employee classification supports morale and compliance and prevents fines and legal risks
- The IRS has a series of rules that help businesses determine the difference between employees and contractors
- OnPay’s automated payroll software can support correct classifications and ongoing compliance
This employer’s guide covers employee classification fundamentals, audit considerations, reporting requirements, 1099 forms, backup withholding, and how to stay ahead of the curve.
What is employee classification?
In technical terms, employee classification is the process of appropriately categorizing your workers according to federal and state legal guidelines. The most common classification distinctions are between employees (who can also be divided into exempt and non-exempt employees) and independent contractors (also known as freelancers or gig workers). Classifications are determined by a set of facts and circumstances analyzed through rules established by agencies like the IRS and the Department of Labor (DOL). It’s important to understand that classifying your workers appropriately is a requirement, not a choice.
What’s the purpose of employee classification?
Employee classification exists to ensure legal and regulatory compliance and provide a clear framework for operational and financial planning.
Let’s break down each of these elements:
- Regulatory compliance: Employees and non-employees (like contractors) are required to be treated differently under the law. Correct classification dictates how you withhold and pay taxes (income tax, Social Security & Medicare, and unemployment), determines eligibility for overtime pay under the Fair Labor Standards Act (FLSA), and governs obligations to provide benefits like health insurance or retirement plans under ERISA.
- Operational and financial planning: Knowing a worker’s status allows for accurate budgeting for labor costs, structuring projects appropriately, and defining the scope of working relationships. It also protects your business from potential severe penalties, lawsuits, and reputational damage as a result of misclassification.
A proper classification system makes good business sense to avoid risk and build a fair, transparent, and sustainable foundation for your workforce, support morale, and improve operational efficiency.
What are the different types of employee classification?
Below are the three that your organization definitely needs to know are highlighted in the following charts:
| Worker type | Hours | Income | Benefits | Job security |
| Full-time employee | Usually 35-40 | Salaried or hourly with regular paychecks | Comprehensive packages are common | Higher |
| Part-time employee | Usually 20 or less | Often hourly | May be limited | Lower |
| Worker type | Relationship | Income | Benefits | Hours |
| Temporary employee | Hired by your company or a temp agency | Usually hourly pay | Sometimes offered | Set by your company |
| Independent contractor | Self-employed | Hourly pay or a flat rate | Rarely offered | Set by the individual |
| Worker type | Relationship | Taxes | Benefits | Hours |
| W-2 employee | Hired by your company | Withheld | Eligible for benefits | Works regular hours |
| 1099 contractor | Self-employed, contracted by your company | Not withheld | Generally not eligible | Sets their own hours |
Contractors get paid through nonemployee compensation, which is the term for payments made to individuals who provide services but are not employees.
A final category includes statutory employees, who are considered employees for tax purposes but independent contractors by common-law rules.
Exempt vs. nonexempt: What’s the real difference?
There are several key differences between exempt and non-exempt employees:
Exempt employees are “exempt” from certain labor laws, particularly overtime pay mandated by the Fair Labor Standards Act (FLSA). Exempt employees are not eligible for overtime pay under the FLSA, while non-exempt employees are eligible for overtime pay of 1.5 times their regular rate when they work more than 40 hours in a given work week.
The annual salary threshold for exempt positions is $58,656 or $1,128 a week. In addition to the salary threshold, exempt employees must meet specific criteria. For many exempt employees, this means they must:
- Have a primary duty of “managing the enterprise, or managing a customarily recognized department or subdivision of the enterprise”
- Direct the work of at least two or more full-time employees
- Have the authority to hire or fire employees
For an employee to be considered exempt, they must pass two tests that examine both the employee’s salary and their duties. Let’s walk through these two tests below.
How do I determine exempt versus non-exempt status for a role?
- The salary basis test: An exempt employee must be paid a predetermined, fixed salary that is not subject to reduction based on variations in the quality or quantity of work performed. This salary must meet or exceed the minimum threshold set by the Department of Labor, which is $58,656 per year ($1,128 per week) for 2025. Some states may have higher thresholds, so check with your state’s regulatory authorities.
- The duties test: The employee’s primary job duties must align with one of the FLSA’s standard exemption categories, such as executive, administrative, or professional work. Job titles are irrelevant; the actual work performed and the level of independent judgment required are the determining factors. Examples of exempt duties include managing a department and supervising at least two full-time employees, performing non-manual work directly related to business operations with independent judgment, and performing work requiring advanced knowledge in a field of science or learning.
— David Kindness, CPA
Other employees in certain positions calling for expertise who meet minimum salary requirements may also qualify as exempt. If you’re uncertain about employee status, you can review the Department of Labor’s exemption tests to make a determination, or consult with a legal expert.
Independent contractors vs. employees: IRS rules
Here is what the IRS has to say about independent contractors versus employees:
Behavioral, financial, and relationship control tests
The following tests from the IRS will help you understand the difference between independent contractors and employees.
- Behavioral control: You have control over what an employee does as far as hours, location, and task sequence. Independent contractors set their own schedules and work methods.
- Financial control: You reimburse expenses and pay employees at regular intervals. Independent contractors are paid based on the tasks they perform for your business.
- Relationship control: You will have written employment contracts and benefits for employees. Contractors have a contract for a specific duration or specific tasks, and are not integrated into your overall structure or culture.
Employee miscalculation consequences can include fines, owed back wages, and increased tax liabilities if you misclassify employees. If you need help with determining a worker’s classification, you can file Form SS-8 with the IRS. In addition, the Revenue Act of 1978 includes a safe harbor provision that provides protection for you against retroactive reclassification of workers as employees.
Again, your accountant or legal advisor can offer assistance with IRS rules and regulations. Consult with them if you have any questions or doubts.
Employee classification and compliance: What’s at stake?
Your employee classification policy must encompass compliance. Here are the key elements to focus on:
- Back pay, penalties, audits, and lawsuits: If you misclassify employees, you can face all of these challenges and more. It pays to get it right the first time.
- How misclassification affects health insurance, PTO, and retirement plans: If you misclassify an employee, they can lose eligibility for your company’s health insurance plans, which can have critical consequences. Likewise, misclassified employees may be denied paid time off, sick leave, access to retirement plans, and more.
- State-specific rules to watch: Depending on your location, you may have additional rules to comply with. For instance, California now has an ABC test to determine if a worker is an employee or an independent contractor.
What penalties can my company face for misclassifying workers?
“The penalties for misclassification can be severe and multi-layered, and they can be imposed by both the IRS and the DOL. In addition to being required to pay back wages for unpaid overtime, back taxes for unwithheld income, Social Security, and Medicare taxes, unpaid unemployment, and unpaid workers’ compensation insurance premiums, the IRS and DOL may also charge potentially significant interest and penalties on those amounts. Penalties will vary based on whether the misclassification was accidental or intentional.”
— David Kindness, CPA and OnPay subject matter expert
Furthermore, the IRS can assess penalties under Section 6721 for failing to file correct information returns (like Form W-2 or Form 1099-NEC). Finally, businesses may be required to pay damages and attorneys’ fees for the worker. States may also charge separate penalties and fees for misclassification as well. The amount of the penalty varies by state and the intentionality of the misclassification. In severe cases, intentional misclassification can even lead to criminal charges. The total financial impact can be crippling for a small or mid-sized business, making proactive compliance a wise investment.
The stakes can be high when it comes to misclassification. If you haven’t done so already, create an employee handbook that clearly outlines employee policies and classifications to avoid issues from the beginning.
Seamless and simple
OnPay is very cost-effective, can be processed from any computer, no matter the location, and is very easy to use. The flexibility and on-demand capability are essential since we pay different people with different worker classifications, and each requires different processing approaches. Being able to handle payroll from home when needed is a huge advantage.
— Janet B., Smile Max Dental
How to classify workers correctly: A step-by-step guide
Here is a step-by-step guide to effectively implementing your employee classification policy:
- Determine what type of workers you need before the hiring process begins: If you’re clear on whether you’re looking for independent contractors or full-time employees, this process will be much easier.
- Match roles with IRS and FLSA guidelines: When in doubt, turn to the Internal Revenue Service for official info and guidelines.
- Integrate classification into payroll software setup: If classification is a part of your payroll, you will prevent mistakes and ensure proper payments.
- Review IRS common law rules. Examine behavioral, financial, and relationship test results.
- Document contracts. Document and then document again. The more explicit your contracts and classifications, the better.
- Review relationships regularly. Sometimes someone starts as a contractor but then shifts into full-time employee work. To that end, regularly review your contracts to determine if changes are needed for classification purposes.
Finally, make sure you stay prepared for audits and consult the experts as needed.
Understanding employee classification keeps headaches to a minimum
Getting employee classification right from the start saves employers significant time, money, and stress down the road. While the distinctions might seem like bureaucratic details, they directly impact payroll processing, worker benefits eligibility, and audit exposure.
The key is building classification decisions into your hiring process rather than treating them as an afterthought. When you’re clear on whether a role requires an employee or contractor before posting the position, you can structure the relationship properly from day one.
Remember that worker relationships can evolve over time. Regular reviews of your classifications help catch shifts before they become compliance issues. A little upfront attention to these details prevents much bigger problems later—from back-pay penalties to documentation headaches during audits.
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Jon Davis is the Sr. Content Marketing Manager at OnPay. He has over 15 years of experience writing for small and growing businesses. Jon lives and works in Atlanta.