Misclassification of employees as independent contractors
IRS reclassification as an employee occurs where persons claimed as (or claiming to be) independent contractors are recategorized by the Internal Revenue Service (IRS), or by state tax authorities, as W-2 employees. The reclassification can result in the imposition of fines, penalties, and back-taxes for which the employer is generally liable. These amounts could cost a business large sums of money. The U.S. Government Accountability Office (GAO) (formerly known as the General Accounting Office) reports that the IRS claims to lose millions of dollars in uncollected payroll, social security, Medicare, and unemployment insurance taxes because of misclassification of independent contractors by taxpayers. According to IRS Commissioner Mark W. Everson in a statement made November 3, 2005, IRS audits of small businesses organized as corporations increased from 7,294 in 2004 to 17,867 in 2005. 
Who is being classified?
Employers must report the incomes of employees and independent contractors using the IRS form W-2 and 1099, respectively. Employers pay different taxes (i.e. Social Security and Medicare taxes, unemployment taxes, etc.) on the wages of a worker that is classified as an employee. However, these same taxes are generally not paid by the employer on the compensation of a worker classified as an independent contractor. Instead, the worker classified as an independent contractor is responsible for their employer's share of the taxes when he or she pays self-employment taxes at the end of the year. If an employer intentionally or mistakenly classifies an employee as an independent contractor, the employer is then at risk for being heavily fined and paying back-taxes.
Being classified as an independent contractor also affects whether an employee can receive unemployment benefits. In many states, independent contractors are not eligible for unemployment benefits because nothing has been paid into the unemployment insurance fund on their behalf. Employers who have no W-2 employees are not required to make payments to the unemployment insurance fund, and since no one can file a claim for benefits, they don't have to worry about their accounts being charged any extra. So should a misclassified employee lose his job through no fault of his own, that employee has to contact their state Unemployment Agency (for example EDD in California) and file a claim. EDD would then investigate the matter and make a determination as to wether the worker was an employee or a contractor, and award unemployment benefits accordingly.
Employee vs. independent contractor
According to the IRS, an employee is anyone who performs services for an employer if the employer can control what will be done and how it will be done. This was codified in revenue ruling 87-41, and is generally called "the twenty factor test".  Independent contractors are defined so if the payer or employer has the right to control or direct only the result of the work done, and not the means and methods of accomplishing the result. There are also other categories such as non-employees, which include direct sellers.
Employees and independent contractors have very different benefits. Employees are entitled to the protection of wage and hour laws and are protected from discrimination and retaliation by employers. Employees are legally entitled to family medical leave and benefits such as medical insurance and pension plans. Employees are entitled to bargain collectively with their employers. Employees are entitled to workers’ compensation for job-related injuries and employers must pay into social security, Medicare, and unemployment insurance for their employees. None of that applies to independent contractors; they aren’t entitled to the legal protections of an employee and they pay their own social security, Medicare, and unemployment taxes in full. 
Service sector employees are more likely than others to be misclassified as independent contractors. Commonly misclassified positions include delivery and taxi drivers, nurses and home health aids, housekeepers , and adult entertainment workers. 
IRS Documents: Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding
If it is still unclear whether a worker is an employee or an independent contractor the IRS Form SS-8 can be filed with the IRS.
Mitigating IRS reclassification risk
||This article contains instructions, advice, or how-to content. (September 2009)|
One must determine if an evaluation of a worker’s classification is necessary. Independent contractors on an approved vendor list, or whose services are on an exempt services list, may not require an evaluation. Also, independent contractors immediately willing to become W-2 employees through a Portable Employer of Record will not require an evaluation. If the analysis is necessary, a qualified Compliance Officer attempts to produce an accurate judgment of the workers classification, and delivers his or her written recommendation to the employer.
A Compliance File, including all necessary supporting documentation for the compliant independent contractor, is kept on file in the event of an audit.
- "Independent Contractor (Self-Employed) or Employee?", irs.gov
- "IRS Offers Tips on How to Correct Reporting of Misclassified Employees", irs.gov, March 27, 2006
- "Avoiding IRS reclassification of workers as employees.", Tracy A. Freeman, The Tax Adviser, February 1 1996
- "FedEx Drivers Fight for ‘Employee’ Status, Rights", Megan Tady, The NewStandard, July 18, 2006
- "Sebelius Announces Campaign to Ensure Fairness for Kansas Workers and Businesses", infozine.com, July 11, 2006
- "Waxman: Blackwater may have evaded millions in taxes", Justine Redman, CNN, October 23, 2007
- "Employee Benefits," irs.gov
- "In the Sharing Economy, Workers Find Both Freedom and Uncertainty", Natasha Singer, New York Magazine, August 16, 2014
- "I was 1099’d: Employer Liability for Independent Contractors in the Service Sector", Melinda Pilling, Rukin, Hyland, Doria & Tindall, October 8, 2014
- "Are Exotic Dancers Employees or Independent Contractors?", Rebecca Davis O'Brien, The Wall Street Journal, December 2, 2014