The IRS uses three main categories to determine worker classification: behavioral control, financial control, and the type of relationship. If an employer controls how, when, and where a person works and provides tools or training, the worker is more likely to be classified as a W-2 employee. Independent 1099 contractors usually control their own schedules, provide their own equipment, and take on financial risk.

Misclassification can result in severe penalties from the IRS, including back taxes, interest, and fines. Employers may also face audits and lawsuits. To avoid this, it's essential to correctly classify workers from the beginning and use contractor management software to maintain proper documentation and compliance.